Convertible bonds – An alternative for equity and bond investors alike

Stephanie Zwick, Head of Convertible Bonds at Fisch Asset Management in Zurich, expects to see inflows into the convertible bond asset class during the remainder of the year. “In the current market phase, convertibles make for an attractive alternative to both equities and bonds. Equity market levels are high and the economic outlook is starting to look bleaker, so equity investors are increasingly on the lookout for downside protection, while bond investors need investment opportunities capable of generating higher returns due to concerns about interest rates.”

As with equity markets, the US is the driving force for convertible bond markets. One example of this is year-to-date performance, where US names are leading, but it is especially true of new issuance. “The volume in 2018 is very encouraging and, at the end of August, stood at around USD 75 billion according to data from Thomson Reuters. Extrapolated, this could turn out to be the best year since the financial crisis. The fact that the world’s largest economy has produced almost half of new issues is remarkable,” said Zwick.

“Low issuance out of Europe may come as a surprise at first, but it makes sense when you look at the four main convertibles markets: the US, Europe, Japan and Asia ex Japan. Rising interest rates in the US have led US companies to issue more convertibles as a cheaper means of refinancing. Since convertible bonds are issued with a lower coupon than corporate bonds, refinancing by means of convertibles is particularly attractive, from the issuer’s point of view, when interest rates are going up. We saw many well-known issuers come on the scene, such as Twitter and Illumina. Other companies, such as Etsy, are newcomers to the convertible bond market. The sector breakdown was another striking feature. Around half of new issues in the US to-date have come from the technology sector, followed by healthcare, at 14%,” said Zwick.

Technology stocks, which account for around a quarter of the entire equity market in the US, are a strong source of returns within the convertibles market this year. “However, the positive price trend in the US is not reflected across all global convertible indices. This is because European issues form a large share of investment grade convertible indices. For an active asset manager, this year it has paid off to overweight the US, technology and cyclical securities. That said, a close examination of credit quality and business models was required to avoid taking on too much risk, especially in the case of the many software companies that have issued convertible bonds. Ultimately, convertibles are a type of bond, and repayment at maturity remains a key feature of investing in them,” Fisch’s Head of Convertible Bonds remarked.

Looking ahead, Zwick went on to say, “We expect market volatility to increase because the latest economic indicators out of Europe and China are weaker. While China’s central bank is taking countermeasures and is once more pursuing a relatively expansionary monetary policy, the European Central Bank is still following the same course as the US Federal Reserve, but with a time lag. Our outlook for equity markets is still slightly positive, but convertible bonds have a lot going for them in these market conditions: in increasingly uncertain times, they offer the investor an optimum risk/reward ratio.”