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More and more voices have recently been heard warning of an imminent recession. “True, there are some signs that the economy is weakening, but we also see some positive signs pointing to a renewed recovery in the global economy. Both our macro and equity models continue to send out positive signals. The combination of moderate economic growth, expansive money policy and low inflation that we have seen for some time now remains intact. Meanwhile, investor sentiment continues to be muted, and this is preventing the formation of market bubbles. Historically, such a combination has always provided a favourable and stable environment for financial markets. As such, even the slightest calming of the ongoing trade dispute could lead to significantly higher equity and credit markets, but also higher interest rates”, said Ute Heyward, portfolio manager at Fisch Asset Management in Zürich.
However, there is no need for investors who place more emphasis on risk factors in their assessment to throw in the towel at this stage. Instead, they should take a closer look at convertible bonds, pending the next phase of the economic cycle. By virtue of their built-in protection mechanism and their asymmetric risk-reward profile, convertible bonds can limit potential losses. “However, if financial markets continue to shine, they should also continue to capture further upside”, the convertibles expert said.
By way of illustration, there have been three phases of severe market declines in this century, which Fisch Asset Management has researched. “The first one lasted from 2000 until 2002, when the bursting of the dotcom bubble triggered losses of 45 percent on global equity markets (as measured by the MSCI World USD). During the same period, convertible bonds gave up less than 20 percent (based on the Thomson Reuters Global Vanilla Index Hedged USD). Furthermore, steady issuance of new convex convertibles replenished the CB universe regularly and thus ‘regenerated’ its equity sensitivity”, Heyward said.
With the outbreak of the financial crisis, the period from autumn 2007 to early 2009 was also an unprecedented setback for the CB market, which was overwhelmed by such unusual factors as a severe lack of liquidity and forced sales. CB prices fell by about 35 percent, but that was far less than the losses suffered by equity markets, which shed more than 50 percent. Thanks to the pull-to-par effect (i.e. a bond price’s gradual shift over time towards its par value or its redemption price), convertible bonds clawed back their losses twice as fast as equities.
In the ensuing years there have only been a few major global market downturns, in which losses have proved less severe, but such instances have still demonstrated the attractive and resilient properties of convertible bonds. For example, in the fourth quarter of 2018, equities plunged by 18% while convertible bonds lost just 8%, and subsequently quickly rallied to new highs in the first quarter of this year. In conclusion, says Heyward: “The generally lower drawdown of convertible bonds is synonymous with lower risks for investors. Accordingly, now is potentially a good time to afford this asset class closer consideration. The unique attributes of CBs means that they offer a more defensive route via which investors can gain equity market exposure and, over the longer term, can deliver equity-like returns with lower volatility. With equity market fluctuations looking increasingly likely in the period ahead, convertible bonds are an attractive alternative from this point of view.”