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Subdued volatility has taken the options within convertible bonds down to very attractive valuations. Christopher O’Dea asks if now is the time to start building positions for choppier markets ahead

It’s often said that the best defence is a strong offence. But at the moment institutional investors can have it all, because defensive protection for equity allocations is selling cheap.

That protection comes in the form of convertible bonds, which provide the protection of a bond and coupon income in tandem with the option to convert the debt to equity in the issuing company.

In fact, portfolio managers say the cost of buying convertibles is more attractive than it has been since the financial crisis, and with considerably less credit risk on the underlying bonds than existed then. Convertibles managers are producing 6-7% returns with volatility of just 4-6%, reflecting low implied volatility in global markets that are flush with liquidity from central bank stimulus programmes.

But there are differences in valuation between regions, and managers use a variety of approaches that seek a performance edge by looking beyond the headline numbers about implied volatility. The result is that institutional investors have a range of options depending on their risk tolerance and their objectives for an allocation to convertibles in a broader portfolio.

While convertibles globally are slightly cheap, there are regional differences, says Antony Vallee, head of global convertibles in the Global Multi-Asset Group at JPMorgan Asset Management. 

“Asia is probably the cheapest I’ve seen since 2012,” he says. “The US, on average, is cheapest I’ve seen since 2012, and Europe is near fair value, leaning slightly to the cheap side.” 

Vallee’s team, which manages about $5.7bn in convertibles, builds portfolios from an active universe of about 800 bonds selected from the global universe of convertibles over $100m that are actively traded by multiple brokers. Asia-ex Japan and Japan are trading at a discount, with high-yield and non-rated issues being the cheapest, he says. At nearly 15%, Japan is the second-largest weight in JPMAM’s global convertibles fund, after the 34% weight in the US.  

Japan is also the “main bet” at Zurich-based Fisch Asset Management, says Beat Thoma, who oversees $6bn in convertibles as the firm’s head of portfolio management. New issuance – mostly investment-grade – has been steady, and Thoma says implied volatility of 30-32% is moderate, given the strength of Japanese stocks under a quantitative easing (QE) regime. The low level of implied volatility makes convertibles an attractive proposition for institutions, Thoma says. “Implied volatility is an insurance of capital, and if there’s all good news, there’s no demand for insurance,” he says. 

A US economic blip, or the end of global monetary easing could stimulate implied volatility, he adds, but convertibles will remain attractive as long as markets are sedate. 

“Everything is still based on money printing, which makes people less aware of the risks,” he says. As a result, “the price for capital protection should be higher”, he contends. “Convertible bonds have highly interesting protection features at a fair price. Probably, the price should be higher.” 

Coupon income and movement in the underlying equity ultimately determine returns, while market-wide theoretical values reflect prevailing supply and demand dynamics, says Justin Craib-Cox, convertibles fund manager at Aviva Investors

“All else being equal, seeing the market trade slightly cheap means that a long-only investor has the benefit of a tailwind – assuming that the underlying cheapness of the convertible bonds moves back to a fair value,” he says.

Going into the September 2014 sell-off, convertibles enjoyed more demand than supply, which drove up theoretical values to a premium of about 2%. While there were no major sellers of convertibles at the time, investors in the asset class left cash on the sidelines, and theoretical values fell back below fair value simply because no new buyers appeared. 

“There are still opportunities for cheap valuations, given that if the average is at or below fair value, there must be convertible bonds that are trading cheap”

Justin Craib-Cox

Investors have been “putting cash to work in recent months”, Craib-Cox says. “There are still opportunities for cheap valuations, given that if the average is at or below fair value, there must be convertible bonds that are trading cheap.”

The goal of putting cash to work is to generate returns, of course, and assessing return potential also requires supportive fundamentals. 

“There’s no point being invested in a theoretically cheap bond if the credit market and equity market don’t improve,” says Michael Reed, a partner and senior portfolio manager at BlueBay Asset Management. With ECB stimulus under way, and China likely to stimulate its economy, Reed says the search for asset yields will continue. “That’s forcing a lot of pension funds to move into higher-yielding issues, reducing the refinancing risk for high-yield and convertible bonds.”

High demand also inflates prices for better-yielding assets, forcing managers to utilise all their tools to identify and capture relative value, says Reed. European investment-grade convertibles, for example, are a niche that’s relatively over-valued in the current market. 

“When we find areas squeezed by excessive demand are offering relatively less value, we transfer out of convertibles into pure equity or options,” he says. This enables his team to position portfolios to benefit from macro changes. One that could be on the way is rising equity volatility – it has remained subdued while rising in  foreign exchange and interest rate markets. “I worry that it will at some point filter into equity.”

At some point, volatility is going to pick up, says Davide Basile, portfolio manager of the $1.8bn (€1.7bn) RWC Global Convertibles fund. The fund always has a positive exposure to volatility, and the implied volatility of convertibles is currently attractive, he says. Uncertainty about the pace and timing of a US interest rate increase, and its effect on stock prices, means it’s a good time for institutional investors to protect capital, preserve the opportunity to participate in selective equity stories, and reduce exposure to bond prices. Convertibles, he notes, enable investors to reduce duration substantially – many convertible portfolios sport durations of about three years – without sacrificing total return or reducing credit quality in order to boost yield. 

“The main question is how much are you paying for this optionality,” Basile says. “In the past several years, convertible value levels have been very attractive.”

Some managers follow a different drummer. “In my opinion, it’s quite impossible to find a way to compare the implied volatility of convertible bonds to other implied volatilities,” says Jean-Edouard Reymond, head of the convertibles team at Geneva-based Union Bancaire Privée (UBP). The problem is one of market structure, he says. Convertibles are typically a conversion option with a five to seven-year maturity, relatively long compared with the two or three-quarter maturities of standard options traded on liquid markets. Reymond instead takes a value-investing approach – convexity at a reasonable price, or CARP – that leads the team to bonds with implied volatilities below the market level. “So we are immune to further declines in volatility,” he says.

The result, says Reymond, is that “if you have a pure convertible bond portfolio built around convexity, you will have less debate regarding

valuation”. The approach helps avoid one of the key pitfalls of convertible investing – chasing price moves generated by market sentiment. When most investors are bullish, he says, high-delta convertibles are expensive, and when most are bearish, low-delta names are expensive. Better, he says, to build a portfolio of bonds positioned to deliver a particular combination of upside and downside capture. The most popular combination is a defensive profile that aims to deliver 45% of equity market upside while limiting downside participation to 12% of equity market moves.

One thing is certain – at some point turbulence will return to both equity and credit markets. That’s when convertibles can be particularly beneficial. During the volatile conditions of the 1970s, convertible bond strategies often provided better returns than either the stock market or straight fixed income. Volatility may be low today, but market cycles haven’t been repealed, and when the tumult resumes convertibles may again offer the best of both worlds for investors.

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