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Diversified credit: think convertibles

With an environment of constantly accommodative central banks and low rates largely behind us, a new economic landscape is shaping up.

While convertible bonds became a somewhat unloved asset class in the old world of QE and suppressed sources of uncertainty, the return of dispersion, rising volatility and higher interest rates are all factors that facilitate their performance.

As a standalone asset class the outlook is positive, while for multi-asset investors in search of diversified sources of credit, they have become a compelling allocation proposition.

While credit investing typically rewards investors for taking on risk through holding lower-rated debt with higher yields, the appeal of convertibles is something different – a bond with a credit floor and the potential for capital appreciation, provided by the equity conversion element.

Within multi asset credit (MAC) portfolios, this differentiated return element (the potential to capture equity upside) complements rather than echoes other asset classes, providing a potential alternative alpha source and increasing diversification.

They fit, improve and enhance: we believe a convertible bond allocation has a valuable place within a MAC portfolio – here are seven reasons why:

Although convertible bonds offer investors exposure to equity markets, they display much lower volatility than direct equity investments. Historically, convertible bonds have experienced volatility levels about half that of equity markets and more akin to corporate credit markets. From that perspective, they have a natural place in MAC portfolios.

Figure 1: 1-year rolling daily volatility

Figure 1: 1-year rolling daily volatility

Source: Bloomberg, BlueBay Asset Management to 12 March 2018. MSCI World Net Total Return USD Index; Thomson Reuters Global Focus Convertible Index (USD); BoAML C0A0 Index; BoAML H0A0 Index; BoAML G4O2 Index.

We view convertible bonds as a high-quality asset class from a credit perspective. Whereas with other fixed income instruments you typically have to go down the ratings ladder to increase return potential, convertibles remain largely investment-grade rated, with the return coming from the equity market exposure, rather than carry.

Figure 2: Global convertible bond universe credit profile

Figure 2: global convertible bond universe credit profile

Source: BlueBay Asset Management as at 31 March 2018. Note: 1. These ratings include BlueBay internal ratings for non-rated issues, 2. In the high yield portion of the convertible bond universe, most issues are rated BB.

We believe convertible bonds are best suited to an environment where uncertainty and high interest rates prevail. Here, equity investors see the benefit of investing in convertible bonds for portfolio protection. At the same time, fixed income investors are often attracted to convertible bonds as they appear ready to give up some yield to capture future growth and capital appreciation.

We believe the environment of constantly more accommodative central banks and low rates is behind us, which opens a window of potential opportunity for convertibles. We would also highlight that despite convertible bonds’ lack of popularity over the past few years, they have nevertheless offered attractive absolute returns.

To illustrate, below shows the performance of the Thomson Reuters Global Focus Convertible index over the past five years.

Thomson Reuters Global Focus Convertible index

Source: Thomson Reuters as at 31 March 2018

A rise in rates usually corresponds to stronger economic growth. This means that in periods of rising rates, equities tend to benefit and the equity component of convertible bonds typically generates outperformance versus government bonds, as shown in Figure 3.

Figure 3: Convertibles have produced positive returns in periods when government bonds suffered significant losses – 1994-2013

Figure 3: convertibles have produced positive returns in periods when government bonds suffered significant losses – 1994-2013

Source: Bloomberg as at 31 December 2013. Based on the last 20 years when government bonds have posted losses greater than 5%. 1 Convertible bonds: Thomson Reuters Global Focus Convertible Bond Index; 2 Government bonds: BAML 7–10 Year US Treasury Index. Past performance is not indicative of future results.

Our view is that we have entered the late stage of the monetary cycle. This phase has historically been characterised by an increase in risk asset volatility, led by higher short-term rates; economic activity remains strong and corporate earnings expand; companies usually spend their cash on CAPEX and acquisitions; credit fundamentals tend to deteriorate gradually. During this phase, credit spreads start widening but equities continue to do well. We think the current cycle is similar to previous ones in the sense that we see signs of these dynamics developing.

Such an environment is favourable to convertible bonds; rising equities drive positive returns for the asset class and the equity option embedded in convertible bonds can benefit from rising volatility. Additionally, convertible bonds have lower spread sensitivity than traditional credit asset classes and therefore we view them as less impacted by any potential widening.

We believe that the current environment should lead to a strong pick-up in M&A activity. The cost of financing is generally cheap and companies seem to have large cash balances. Additionally, one of the key concepts for CEOs is ‘disruption’. A natural way to fight the risk of disruption is to gain scale in new technologies through acquisitions.

Convertible bonds are one of the asset classes set to benefit most from rising M&A activity. The convertible bond universe has a strong bias to high-growth sectors, compared to the main equity and bond indices.

Figure 4 shows a breakdown of the Thomson Reuters Global Focus Convertible index by sector, highlighting the weight of new-economy, high-growth sectors where M&A activity is structurally stronger. In addition, most convertible bond prospectuses offer explicit takeover protection that can enhance significantly the value of the embedded equity option. Through this ‘ratchet’ mechanism, convertible bonds often generate returns more in line with equities than bonds in the case of a takeover.

Figure 4: M&A activity is structurally stronger in new economy, high-growth sectors

Figure 4: m&a activity is structurally stronger in new economy, high-growth sectors

Source: BlueBay Asset Management, as at 31 March 2018. *BlueBay Asset Management internal classifications.

Figure 5: Strong historical link between global M&A and convertible performance

Figure 5: strong historical link between global m&a and convertible performance

Source: Bloomberg, as at 31 March 2018

One headwind faced by convertible bonds has been the size of the asset class. A larger universe tends to increase the popularity of the asset class, attracting new investors and creating a larger dedicated investor base. It cannot be denied that convertible bonds are not held by many larger institutional investors on a standalone basis. In the past, the asset class was periodically impacted by flows coming from opportunistic investors looking for a quick return with a shorter investment horizon. We think this weakness can also be seen as an opportunity for potential new investors; we strongly believe this asset class has been under-invested and under-researched in the past.