31st January 2013
The note discusses the merits of convertible bonds. Obviously the manager concerned, Lee Manzi, fund manager on the Jupiter Fixed Interest and Multi Asset Team runs funds that can invest in these instruments. But it does provide some food for thought.
“Investors have a dilemma. On the one hand, major parts of the global economy are on the verge of recession with investors seemingly totally unconcerned, while on the other we have unprecedented levels of monetary and fiscal intervention.
“Intervention has clearly been winning the day, squeezing investors into riskier assets through “financial repression” (measures taken by central banks to push down government bond yields thereby making them less attractive). This disconnect cannot continue forever. A return to economic growth is a vital ingredient for the West to be able deal with its debts and for Europe in particular to implement the structural changes essential to achieving deeper, crucial eurozone integration. However, further necessary paying down of debts and stretched government finances mean countries that need the growth most are least likely to generate it.
“The actions taken by Mario Draghi in the summer to backstop the euro have removed some of the risks of the single currency imploding, but substantial challenges remain. The US authorities have avoided going over the “fiscal cliff” at the 11th hour, but still have the “debt ceiling” (the limit on how much the US can borrow) and “sequestration” (mandatory spending cuts imposed if no agreement is reached) to negotiate. In China, the new government continues to tackle a slowdown in economic growth.
“In this uncertain environment, one option is to consider assets that have the potential to offer asymmetric returns. We consider convertible bonds offer such a proposition. The asymmetry comes from investors receiving the payment of the coupon and the value when the bond matures, known as principal, while at the same time having an option to convert into shares. This offers the potential to benefit from rises in the share price while theoretically limiting the fall in the convertible price.
“Importantly, all other things being equal, convertible investors should be able to capture progressively more of the rise if the underlying equity moves up and progressively less of the downside if the equity falls. Interestingly, convertible bonds returned 7.4% (UBS Global Convertibles index dollar un-hedged) on average each year between 1994 and 2012, versus 5.3% for equities (MSCI World dollar un-hedged index) and with significantly lower volatility.
“The convertible bond market has seen a contraction in size over recent years as subdued equity markets and ultra-low government bond yields have resulted in lacklustre issuance. Convertibles typically allow companies to issue debt more cheaply compared to the straight bond market, in exchange for offering an option to convert to shares. However, record low nominal yields have removed much of this relative funding advantage. In the second half of 2012, equity markets and government bond yields rose, resulting in a pick up in convertible bond issuance. If government bond yields continue to rise, we should see more new issuance and investment opportunities in the convertible bond market in 2013. To us, a rise in bond yields seems likely as they are currently close to historic lows, driven by investor fear and central bank intervention.
“Convertibles, meanwhile, are no longer as undervalued as they were early last year. However, we believe valuations remain attractive versus historic levels and with government bond yields so low, the share ‘optionality’ of convertibles could have significant appeal to investors.”