Yet convertibles remain off the radar for many asset allocators. Indeed, discussion in recent months has centred on the long- term viability of what some say is an increasingly illiquid asset class. But how justified are such concerns? And should more fund selectors consider adding a dedicated convertibles exposure to their portfolios?
Convertible debt is far from new and, according to some sources, was used to finance expansion of the US railway system in the late 19th century. But the asset class has gained greater prominence in recent decades, in particular since the development of Black-Scholes equations in the early ’70s which allowed investors to better quantify the value of its ‘optionality’. Estimates of the current size of the international convertibles market range between $400bn and $500bn (€310bn to €390bn).
Key to the appeal of convertibles is their ability to produce attractive risk-adjusted returns. Because the price of a convertible bond is correlated with that of its underlying equity, but its downside is limited by the bond floor (the lowest value a bond can fall to), the structure can have a powerful compounding effect in volatile markets.
Data from Morgan Stanley Investment Management (MSIM) and Bloomberg shows the UBS Global Convertible Bond Index returned 6% per year from its launch at the start of 1994 to the end of 2011, in dollar terms, compared with 5% for MSCI World.
Fund managers say convertible bonds are especially desirable in current market conditions. “The main reason they are different [to equities] is you do not own stocks – you own stock options,” explains Tom Wills, an executive director and portfolio manager of the €850m Global Convertible Bond Fund at MSIM. “In periods of extreme market uncertainty like today, those options are useful. Investors are unsure whether equities will collapse on a difficult exit for Greece or other events in Europe, or Chinese growth, or US politics.
“On the other hand, equities are cheap and they could recover strongly over the next three to five years, and investors do not want to be completely un-invested in stocks. So when is a great time to own convertibles? Exactly in that situation.”
Davide Basile,manager of the €770m RWC Global Convertibles Sicav, and the former head of convertible bonds at MSIM, takes a similar line, arguing convertibles is “the asset class of choice”. In addition, he says, a structural change in the investor base has boosted the appeal of convertibles for long-term investors seeking low volatility assets.
Before 2008, the sector was dominated by arbitrage strategies that exploited short-term pricing inefficiencies. But many such highly geared investors were forced to rapidly deleverage towards the end of that year, following the collapse of Lehmans and consequent worsening of the credit crunch.
While the sell-off inflicted considerable pain on the convertibles market, it also allowed fundamental investors to reassert their influence. Indeed, Wills says “almost every cent” that has gone into the asset class during the past four years has come from the long-only side, and the market has become “about two-thirds dominated” by stable, long-run money.
Basile adds: “The sell-off was a catalyst or a lot of institutional investors to look at the asset class again, and start making a decision based on the credit dynamics, as opposed to strategy dynamics. So the long-only investor base has been more dominant, and you tend to see the asset class is more fundamentally driven, as opposed to technically driven.”
Our allocation to the US tends to be larger than some of our competitors. So for us, liquidity is really not an issue, because the US remains quite deep and quite liquid
manager, RWC Global Convertibles Sicav
Matthew Ennion, associate director at Lemontree Wealth, part of the RSM Tenon group, is one such investor. After taking a short-term convertibles allocation at the start of 2009, to take advantage of depressed valuations, Ennion has since returned to the asset class with a longer-term investment horizon. “We take a total return approach to what we do, so it is good to put it in there as a small allocation.” Lemontree favours the €620m Jupiter Global Convertibles Sicav, he adds, owing to its plain vanilla approach.
But while some fund selectors are using convertibles as a diversifier, others will not have been encouraged to follow suit by re- cent press coverage of the asset class. A story published in the Financial Times in July, for example, warned falling issuance levels could threaten the long-term viability of the global convertibles sector. One fund manager quoted in the article forecast the market capitalisation could become “too small” within 18 months if activity fails to pick up.
Issuance has indeed fallen in recent years, and according to UBS may dip below $50bn in 2012, less than a quarter of the amount issued in 2007 (see bar chart). Two key factors lie behind the decline.
First, companies tend to issue convertible bonds when interest rates are high – given the ability of the structure to reduce borrowing costs. Wills says a company that would typically issue “straight” bonds with a 5% coupon might issue a convertible at between 2% and 3%. But, with interest rates so low, there is less incentive to take this option and Wills highlights the example of Japan, which accounted for 30% of the global convertibles market in the mid-’90s, but now accounts for less than 10%.
Second, companies are unlikely to offer an equity call option if they believe their stock is priced below fair value. “So when rates and equities are low, which is exactly where we have been for the past year, convertible issuance is going to be weak,” says Wills. Nevertheless, Wills and Basile are sanguine on the future of the asset class. Basile disputes claims the European convertibles market has seized up, and says he examined (and declined) an issue by a German real estate company in July.
Depth and liquidity
Liquidity is only a significant concern for funds with assets of more than $2bn to $3bn, he suggests, or which have little exposure to US companies – about 50% of the market. “Our allocation to the US tends to be larger than some of our competitors,” Basile adds. “So for us, liquidity is really not an issue, because the US remains quite deep and quite liquid.”
• Upside equity exposure combined with bond-like downside protection should make convertible bonds a popular asset class.
• Yet despite ongoing equity volatility, convertibles are under-represented in the majority of private client portfolios.
• Concerns have been raised about the liquidity of the market, but fund managers say it is sufficiently deep.
Wills, meanwhile, says the global market needs $100bn of new issuance each year to maintain its current size, based on an average bond life of five years. He says: “We are only putting back $60bn or $70bn two years running. If that happened for five years in a row, then the market would shrink from its $500bn-plus peak to about $300bn or $350bn. Is that a disaster? When I was investing in convertibles in the late-’90s, the market was $300bn, and it felt quite normal at the time.”