Investment: Convex protection

With record-low corporate spreads and volatile equity markets, is it time to take a closer look at convertible bonds? Carlo Svaluto Moreolo investigates 

“It’s a tough time for convertible bond managers,” says Cédric Daras, senior fund manager at RAM Active Investments. Finding long-term value in the market has been hard for some time. And since issuance has also slowed in recent months, managers have a more difficult job than usual in selecting securities.

Yet convertibles seem the natural answer to a classic asset allocation conundrum: how can investors participate in equity markets upside while keeping a safety cushion against market falls? 

Convertible bonds are corporate bonds with an embedded call option on the issuer’s stock. This gives the investor the right to convert the instrument into shares at a pre-agreed price.

The call option provides investors with participation in the issuer’s rising stock market, but investors in a convertible get coupon payments and repayment of the principal at maturity. From a pricing perspective, the convertible will tend to behave more like a bond if the price drops below a certain level. 

Convertibles are generally issued by corporates for various reasons. Most importantly, the cost of issuing a convertible is usually lower than a issuing a straight bond, reflecting the exposure buyers get to the issuer’s equity price. 

Often a convertible bond is a more likely option than equity or straight bond issuance for ‘growth’ companies in need of financing. An important feature of these instruments is that investors generally do not require a rating, which cannot be said for other bonds. About a half of the universe is unrated, says Daras.

According to Carl Fox, head of the convertibles portfolio management group at Union Investments, record lows in corporate spreads are one of the reasons for the sluggish issuance in recent years. “For most issuers it has become increasingly attractive, relatively speaking, to issue a corporate rather than a convertible”, says Fox. 

But issuance hits the brakes particularly when markets are extremely volatile, as they have been since the end of last year. “If you look at issuance since the beginning of the year, where markets have been extremely turbulent, it has been really low. In those situations, both investors and corporate issuers tend to stay on the side lines,” adds Fox. 

Issuance has ebbs and flows, but the sector has lost market share to high-yield bonds. Eli Pars, co-CIO and head of alternative strategies at Calamos Investments, the $20.1bn (€18.3bn) US-based asset manager, says: “The big question is will convertibles get back some of the market share they lost to high-yield in the last five to 10 years? After periods of high volatility, the primary market in high-yield tends to stay muted for longer. Whereas, in convertibles, the market tends to reopen much quicker as volatility subdues.” Today the size of the global convertible market is just over $300bn (€272bn), according to Calamos Investments. 

The long-term performance of the asset class is encouraging. Thomson Reuters’ global convertible bond index has grown 17.7% over the past five years.

Stress tests performed by Union Investment show how a 100% allocation to convertibles can outperform a 50/50 equity/corporate bond portfolio. This applies in extreme conditions of both rising and declining equities and bond yields (see figure).

The property that gives the asset class this outperformance potential is convexity. The term is used to describe the non-linearity in the relationship between the price of the issuer’s equity and price of the convertible. This means that when the equity price falls, the bond price falls to a lesser degree, and vice versa. 

According to Union Investment’s calculations, the one occasion when a 100% convertible portfolio will not outperform an equity credit portfolio is falling yields. 

But John Calamos, co-Cio at Calamos Investments, explains: “In a straight up-market you give up some of the upside. But we do not try to time the market. The protection on the downside is embedded in the portfolio, so we’re willing to give up some of the upside in a straight up-market in order to get that downside protection.” Furthermore, Calamos points out how convertible portfolios have shown particular resilience in rising-rate environments. 

So how has long-term value become hard to find? Partly, it has to do with the value of the underlying securities. Investment in convertible bonds tends to be, by and large, a bottom-up game. Managers want to develop an understanding of the factors driving the issuer’s share price as well as its credit quality. 

Jean-Edouard Reymond, head of convertibles at UBP, says the approach of his strategy is “purely bottom up”. The equity and interest rate sensitivity of the portfolio is adjusted with derivatives, but the focus is largely on fundamentals. “We pay attention to the features that are important for us on the equity side, in order to identify stocks for which analysts underestimate earnings profile,” adds Reymond.

But managers must also pay attention to technical factors, and there may be a tendency to position portfolios tactically around those factors. 

Daras and his colleague Olivier Mulin, also a senior fund manager at RAM Active Investments, explain that the convexity profile of a portfolio can look different from short-term and long-term points of view. A portfolio that provides immediate protection from shocks in the equity markets does not necessarily benefit investors in the long term.

The firm calculates convexity on a 12-month horizon, and optimises the portfolio accordingly.

The convexity of a convertible over a 12-month horizon, according to Daras and Mulin, is mainly driven by two elements. One is the carry of the bond part of the convertible, the other is the amortisation of the premium, or the difference between the convertible price and the current market conversion price.

The two elements can offset each other as implied volatility changes. Rising implied volatility increases the value of the premium, thus offsetting the positive carry and reducing the 12-month convexity of the convertible bond.

In other words, to fully benefit from convexity, it pays to buy convertibles when the level of implied volatility is low. “Our goal is really to detect and benefit from price undervaluation technically and fundamentally speaking”, adds Mulin. 

Since the start of the year, according to RAM, there has been the beginning of a correction in implied volatility. The manager has therefore increased its exposure, initially from 50% to 60%. Yet 20% of the universe has a non-convex profile. This warrants caution on certain names, which are generally blue chip, investment grade companies.

Reymond says buying opportunities are coming to the fore, particularly as yields and implied volatility decline. “Recent performance makes convertible bonds attractive on a technical basis at the moment,” he concludes.