Convertibles combine the attributes of different asset classes in one security. As long as their credit quality is not impaired, they can offer unlimited upside with downside protection.
What are we talking about? As described in our 2016 Outlook, convertible bonds (or converts) in many ways offer the “Best of Both Worlds”. Like most traditional bonds, they offer a fixed coupon – mostly lower than on straight bonds – and a set redemption value and date. This means that their downside is limited by the “bond floor”, i.e. the level at which they offer a yield-tomaturity equivalent to a similar standard bond. In addition, they benefit from an embedded option to buy shares in the underlying company at a fixed price (the “call”), giving these instruments sensitivity to equity markets.
The importance of each aspect of converts will vary over time. The value of the call option will rise only gradually when shares are still well below the fixed purchase price, but the closer the prices get, the more valuable the option becomes. Conversely, when equities fall, so does the value of the option – at such times, the bond floor gains in relevance and converts will begin to trade in line with bond markets.
As a result, convertible bonds offer a form of dynamic asset allocation – more equity exposure in bull markets and more bond exposure in bear markets. This duality can offer advantages over a simple 50/50 combination of straight bonds and standard equities, where only half of the holdings benefit from the bond floor and only half have equity sensitivity.
Why now? The presence of the embedded call option in the issue structure means that converts prices are less sensitive to moves in interest rates. We expect rates to rise gradually in coming quarters, putting downward pressure on bond prices. As the chart shows, converts tend to deliver positive returns in times of rising yields, unlike straight bonds.
Also, converts’ lower coupon is less of a handicap in times of low yields and tight credit spreads. Moreover, they were excluded from the European Central Bank’s Corporate Sector Purchase Programme, meaning that values and prices have been less subject to distortion than those of eligible securities.
In addition, equities remain our preferred asset class. If they continue their multi-year rally, converts will benefit from rising sensitivity to this trend. However, we do recognize that demanding valuations can limit the future return potential. In this context, converts’ bond-like characteristics and lower volatility than straight equities are appealing attributes. Furthermore, the chart shows that converts have sometimes even outperformed stocks in a rising-rate environment.
Conclusion. In Chinese philosophy, the importance of opposite but complementary characteristics is described via the notion of Yin and Yang, or dark and bright. The duality of the whole is greater than the sum of the parts. Similarly, convertible bonds combine the attributes of very different asset classes in a single security. As long as their credit quality is not impaired, convertible bonds can offer unlimited upside potential with downside protection.