We continue to believe inflation and the associated interest rate hikes are the biggest risks investors will face as we move further into 2022. Convertible bonds should be well placed to perform better than other asset classes in this environment because of their structure and their lower effective durations.
What are convertible bonds?
Convertible bonds (“converts”) can be considered a hybrid of a bond and the underlying equity of the issuer. They are bond-like in the sense that they provide investors with regular fixed coupon payments and a principal payment at maturity. Additionally, they provide investors the option to exchange these bonds into equity at a fixed price.
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This is advantageous because these securities can incorporate both fixed income and equity characteristics, meaning they can participate when equities rally whilst limiting the downside exposure. However, the issue facing converts is that investors so often neglect the opportunity because of a poor understanding of the market and the complexities involved in the asset class. This is particularly the case when it comes to valuing these securities because the underlying bond and equity characteristics must both be considered.
Exhibit 1 shows how the value of a convertible bond changes with the underlying equity value, broadly fitting into four valuation scenarios – default, bond-like, mixed and equity-like. With a threat of default, converts retain their bond-like features. Because they are senior to equities in the capital structure, they are valued similarly to bonds, though slightly higher given the equity upside potential. When the underlying equity price increases, the value of the convert will also rise as it increasingly behaves like a stock. In this process, it moves from an ‘out-of-the-money’ position (conversion price > equity price), where it will remain a bond and collect bond payments to an ‘in-the-money’ position (equity price > conversion price), where it is more likely to be converted to equity.
What are the features and risks of converts?
Risks that investors face include those inherent to fixed income and equity securities as well as convert specific risks. Credit risk tends to be the biggest component of a convert, largely because issuers in this space are typically lower-rated, smaller companies looking to access capital at attractive (i.e. lower) interest rates.
Outlook for converts
During periods of high and rising inflation, core fixed income and growth equities are likely to struggle. On the other hand, inflation creates a favourable landscape for converts, which have, on average, outperformed both core fixed income and equities across the inflationary periods in Exhibit 2. This is because inflation often leads to increased corporate earnings, increased equity volatility and rising bond yields. Central bankers are also likely to start hiking interest rates to combat inflation. All these factors are supportive of converts.
Soaring interest rates on the back of rising inflation are likely to result in lower equity returns as valuations weaken and price/earnings (PE) ratios compress. More often than not, convertible issuers are able to sustain higher PE ratios by generating sufficient growth through the rising rate period, although there are also examples of that not being the case.
The reasons why converts are able to outperform other fixed income assets is because of their hybrid nature. The equity-like component is able to drive returns when credit spreads are tight. Furthermore, they will also have shorter durations than non-convertible debt securities, which is a significant benefit when rates do rise. Investment-grade corporates and high-yield bonds will have limited upside in 2022 due to tight spreads and issuer-owned call options. Converts, on the other hand, can continue to appreciate through the year and through a mid to late-cycle economy whilst retaining the bond floor.
Converts also provide better downside protection than corporate high yield bonds during periods of greater credit risk because of the ever-present equity upside potential (whatever environment equities may be in). This can be demonstrated with the performance of converts against high yield bonds (see Exhibit 3).
Adding to the inflation and rate risks, 2022 is expected to bring about heightened volatility. We have already begun to see this transpire in the first two months of the year, and we expect this to continue throughout 2022. Inflation risk will be the biggest driver of volatility, but there are numerous other potential events. The ongoing geopolitical risks and uncertainty with Russia and Ukraine, potential conflicts in China and Iran, US midterm elections, and presidential elections in France and Brazil later in the year are all likely to contribute to elevated volatility levels.
Why is higher volatility good for converts? It’s because the convert’s conversion option is usually positively correlated with volatility. This means these assets tend to outperform other asset classes in a high-volatility environment. This can be seen in Exhibit 4. In 2020, converts outperformed most other asset classes including global equities. However, their performance in 2021, a year with a surprising lack of volatility, was lacklustre.
2020 and 2021 were strong years for convertible bond issuance. Supply came largely from new companies that don’t have access to the traditional bond markets, mostly listed companies coming from the recent wave of IPOs. This has resulted in many new issues of disruptive and innovative growth companies.
This has led to the overall size of the global converts market reaching near-record levels that were last seen in 2007. For 2022, we expect convertible bond issuance to continue to remain strong. If history is anything to go by, rising rates have been supportive for convertible bond issuance. Issuing convertibles are simpler and faster than issuing traditional debt and, with higher rates, converts become cheaper thanks to the embedded conversion option.
Supply will largely come from two areas. Firstly, we will continue to see issuance from disruptive growth companies. These companies will want to take advantage of (still!) relatively low interest rates, especially given the expected rise in the volatility of their underlying equity. Secondly, issuers from more traditional sectors (energy, mining, basic materials, etc.) may also come back to the convertible bond market to lock in lower rates, and that is despite them having access to traditional bond markets.
While investing in converts is attractive, getting the sector/style views right will be important. We believe that investors should be more exposed to the converts issued by companies in more cyclical sectors, which should benefit from the reflation trade. Converts issued by high-growth companies, however, are likely to struggle because their underlying stock performance will be more vulnerable to rising rates and inflation.
Investors should consider converts as a part of their portfolios to help navigate the challenges of inflation and rising interest rates in 2022. This asset class clearly has a history of performing well in inflationary periods and hiking cycles. This time is unlikely to be any different. If anything, converts will be more attractive this time, given the supportive issuance trends and the likelihood of heightened volatility throughout the year.
Converts will also be beneficial in market downturns, and there are many triggers that could cause that to happen this year. Supply-chain problems, renewed lock-downs, inflationary fears, central bank tapering and tightening, highly leveraged equity markets and geopolitical risks could all contribute. In the event that any (or all) of these result in indiscriminate selling in 2022, converts should at least be able to absorb some part of downward shocks, which we believe will be important over the next year.
04 March 2022