The present market environment provides a supportive backdrop for convertible bonds, according to Alan Muschott, a portfolio manager at Franklin Templeton (pictured).
“Convertible bonds look more attractive in low interest-rate environments when sources of income may be scarce,” Muschott said.
“Historically, they have tended to perform well during periods of above-average market volatility, when cautious investors with a generally positive view of the equity markets seek risk-controlled equity exposure to reduce potential downside risk.”
Muschott – who manages the Franklin Convertible Securities Fund and the Franklin Global Convertible Securities Fund – added that there was still a lot of room for growth in the convertible bond sector.
Following a peak in 2007, he said, issuance of convertible bonds declined as companies took advantage of low yields and strong flows into the credit markets to issue straight debt rather than convertibles.
The perception then was that raising capital through straight debt was relatively cheap, even when convertible securities were issued at slightly lower rates due to the added concern of share dilution, he said.
Companies were also hesitant to issue convertible securities as equity valuations were inexpensive relative to historical levels, Muschott added.
“More recently issuance has recovered, 2018 exceeded the last several years with $84.5bn worth of global convertible bonds issued, driven by better equity market performance, a rise in interest rates and higher spreads,” he said.
“Catalysts for continued increased issuance include a secular shift in Europe from loan to bond financing and high funding cost for high-yield issuers.
A volatile period
In times of heightened volatility investors naturally seek to create balanced portfolios with low asset correlation. “In contrast to more traditional assets, convertibles tend to offer the potential for low correlation to other asset classes,” Muschott said.
“Historically, convertibles have typically exhibited a low correlation to fixed income and demonstrated imperfect correlation with stocks. This creates potential for an investor to enhance diversification, dampen volatility and improve a portfolio’s overall risk profile.
“However, more portfolio protection can result in the potential for lower returns in a bull market. While a convertible may have less to lose on the downside, it means there is less potential for gain on the upside relative to traditional equities,” he added.
Muschott said investors should be cognisant that those offering potential for higher returns are accompanied by a higher degree of risk.
“Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions,” he continued.
“Bond prices generally move in the opposite direction of interest rates. Thus, as the prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of a portfolio may decline. High yields reflect the higher credit risk associated with these lower-rated securities and, in some cases, the lower market prices for these instruments.”
The US is the centre of the global convertibles market – 60% of the convertible bond universe is made up of US companies.
“Despite facing recent challenges in Q4 2018, opportunities remain in the technology and healthcare sectors in particular,” Muschott said.
“Looking beyond the FAANG stocks which drive the headlines, the technology sector – and its subsectors – represent a diverse range of opportunities, including companies working across software, semiconductor, data analytics, as well as traditional technology companies.”
Looking forward, Franklin Templeton expects to see a diverse group of companies issuing convertibles in 2019, with a skew towards growth businesses, offering an alternative way to create long-term growth opportunities.
“The asset class has ample room for expansion as companies across the globe look for financing and endeavour to attract investors to their common shares at the lowest possible cost,” Muschott said.
“Higher levels of creditworthiness and fiscally healthy companies in the developed markets point to abundant opportunities for participating in corporate growth, even in uncertain markets.”