In the current low yield environment, investors must take more risks to reach higher returns. Amundi’s central macro scenario is overall positive and assumes gentle reflation with global growth around 3%.
However it is important to keep in mind that potential threats – (geo)-political risks, macroeconomic data and central bank actions – could spoil the party.
In light of these challenges diversification remains the name of the game: Avoid putting all eggs in one basket, when you can diversify the sources of return and spread the risks. Furthermore investors improved the risk return profile of their portfolios by moving somewhat away from traditional asset classes with linear risk return profiles towards those offering an asymmetric one. This is illustrated by the strong demand for Minimum Variance1 strategies in recent years. Indeed the portfolio construction technique reduces volatility and drawdowns, while delivering strong returns.
The oldest asset class, which offers exposure to equity markets with an asymmetric risk return profile are convertible bonds. Indeed, the use of convertible bonds as a financing tool has been known since the mid-19th century. At the time, they were issued mainly by US railroad companies to finance their growth. While the conversion option offers equity exposure, the bond component provides downside resilience in case of falling equity markets. Thus, on average convertibles capture two thirds of the equity upside and suffer one third of the drawdowns.
It has been a long time since small to medium-sized companies in growth markets were the only ones issuing convertible bonds. Issuers now range from small and medium-sized companies to large international corporations across the entire credit spectrum, in both developed and emerging countries. Today’s market is characterized by global diversification (regional, sector wise, position in economic cycle…).
In this context, convertible bonds are attractive for the following reasons:
- Enhanced risk return profile of a diversified portfolio : Adding convertibles to an equity, bond or mixed portfolio improves the Sharpe ratio
- Strong convexity: the equity sensitivity is extremely reactive to equity market movements. It rises in bullish markets (like pushing on the accelerator) and recedes in periods of equity drawdowns (acting like a brake).
- Strong issue activity: the dynamic European primary market sustained by blue chip issuers ensures the renewal of the universe and contributes to its overall convexity
- Improved credit quality: the rising number of investment grade issuers reinforces the quality of the bond floor and thus the resilience of the universe in case of market stress
- Low duration: the naturally low interest rate sensitivity of convertibles offers a good diversification opportunity in an environment of rising interest rates
Thus, in the current environment, the convertible bond asset class is ideally positioned to meet investor requirements:
- strong participation in the equity market upside, with
- significant downside protection (parachute effect) and
- reduced sensitivity to rising interest rates.
1. Enhanced risk return profile
Improvement of the risk-return profile of a diversified portfolio
Adding convertible bonds to an equity portfolio decreases overall risk without significantly impacting the performance (and even improves it during the period going from 28/02/1999 to 28/02/2017).
Adding convertible bonds to a bond portfolio increases the performance with a contained increase of volatility.
Replacing a 50/50 equity/bond portfolio with 100% convertible bonds increases significantly the Sharpe ratio.
… Multi-asset managers may be critical vis à vis this last point, but they actually are big users of convertibles
2. Strong convexity
Attractive risk-return profile
Over the long-term the performance of convertible bonds is similar to equities with approximatively half the volatility. This is due to the natural convexity of the product: upside exposure to equity markets and relative downside protection due to the bond component.
Strong resilience in market stress
The table presents periods of stress which strongly weighed on equity markets. During these events, convertible bonds reduced the negative impact by 60% on average.
Strong reactivity of the equity sensitivity to the underlying market movements
The equity sensitivity (delta) of the asset class is very reactive to underlying market movements:
- the delta increases when markets are bullish, acting as an accelerator,
- it decreases in downward markets acting like a brake.
3. Strong issue activity
Active European primary market
Issuance provides for the ongoing renewal of the universe, i.e. it compensates for convertibles exiting via the top (conversion) and those which are redeemed.
The European primary market is dynamic. The CB universe was reshuffled in 4 years. So far, 2017 is on the same pace. New issues typically feature a balanced profile, where convexity is maximised. Primary market regularly brings diversification and structural innovations.
4. Improved credit quality
Improvement of the quality of the convertible universe
The financial innovation of “dilution-neutral convertible bonds”2, which mainly attracts dilution-adverse large cap issuers with a good credit quality, contributed to increase the number of “best in class” companies issuing convertibles. Thus, the proportion of “large cap” and “investment grade” issuers increased considerably, which in turn reinforced the quality of the bond floor. Obviously IG credits are more resilient in periods of market stress.
Low distance to the bond floor provides for a limited equity risk
Convertible bonds feature a distance to the bond floor (i.e. the value of the bond component) close to its long-term average. This distance represents the equity risk, which is currently at a very reasonable level.
Furthermore, as indicated above, the quality of the bond floor, i.e. the capacity to resist in market downturns, has improved as the proportion of IG issuers increased.
5. Low duration
Low modified duration
Convertible bonds have naturally a low modified duration and can thus be used as a diversifying asset compared to traditional bonds. Moreover, it is possible to further reduce the sensitivity in order to hedge the portfolio against an expected rate rise.
Convertibles are de-correlated from fixed income in periods of rising rates
When interest rates rise “for the right reason”, i.e. in an environment of economic growth, convertible bonds continue to perform as the equity engine prevails over the rate sensitivity.
This underpins the rationale of using convertibles for diversification purposes versus government and corporate bonds.
Pierre Luc Charron – Head of Convertible Bonds – Amundi
Stephan Eckhardt, Sabine Duchesne – Investment Specialists – Amundi