Fresh prospects for investors in convertible bonds

With global stock indices outperforming disproportionately over the past few years, many convertible bonds (CB) investors have been left disappointed and decreased their allocations or temporarily exited the asset class. However, with a growing opportunity set and high stock market volatility, there is every reason to expect a sharp reversal of this trend.  It is still early days, but we are already seeing indications that some investors are looking for new entry points into the asset class. Most commonly, investors are curious about the increased issuance and the growth prospects of CB issuers compared to the broader stock market.

Historically, there are multiple periods where CBs outperformed stocks, like in 2020, and periods of significant underperformance, like the most recent past. Most of the differentials are not, however, driven by any CB-specific valuation or features, but rather by the kinds of companies that issue CBs vs. the stock market leaders of the day. Often, the growth-bias of the asset class is very advantageous: In 2020, CBs outperformed as new issues from many Covid- and low interest rates- beneficiary companies provided tailwinds while more cyclical parts of the global stock market lagged. In the years that followed, however, CB issuance dried up, while the global equities took off on the back of a handful of magnificent US stocks, which largely do not exist as CBs. At the same time, many of the stimulus-beneficiary stocks that helped CBs in 2020 pulled back. We`ve seen similar dynamics also around the dot-com bubble and the Global Financial Crisis. The most recent months have been different still with one of the most active CB primary markets in history while some magnificent stocks have shown some cracks.

Going forward, we see some good prospects for CBs to shine through in volatile markets. In a recent study, we found that roughly half of the returns of global stocks in the last 30 years were generated in the most volatile months. While corporate earnings and market uncertainty remain elevated by geopolitics, election results and unstable economic data, growth themes, such as AI, healthcare spending and cybersecurity provide some insulation to corporate profits against cyclical downturns. With many such companies available to invest in via CBs, investors are well positioned to capitalise on medium-term stock price appreciation. Yet, the share prices could be quite volatile as it is the norm for growth stocks to overreact to short-term changes in market sentiment. The built-in convexity (gain from rising stock prices, while mitigating drawdowns through the fixed income features of bonds) enables investors to retain exposure to secular growth while shielding themselves from some of the inherent volatility of those stocks. The lower interest rate duration of CBs vs both investment grade and high yield corporate bonds also helps to navigate an uncertain monetary environment.

Mergers & acquisitions (M&A) activity has also been picking up recently. For CBs, M&A is not only a catalyst for issuance but also for returns: Growth company CB issuers are often takeover targets, and many CBs come with valuable clauses triggering additional returns upon a takeover, sometimes even higher than the stock price appreciation itself.

Furthermore, primary and secondary CB option valuations remain attractive. Outflows from long-only asset managers in recent years and new issuance have led to cheapening of the CB market in terms of implied volatilities which has attracted arbitrageur hedge funds. The current 50/50 balance between hedge funds and long-only is a sweet spot and means more attractive valuations of new issues but without the excessive leverage in the system like prior to the great financial crisis. Such balance makes a stable overall market.

An important thing for investors to keep in mind, however, is that the ability of CBs to limit drawdowns and protect capital when stocks go down is not uniform across all issuers. High financial leverage, high cash burn rate and/or questionable governance/ESG could all result in inferior CB payoff profiles – this is often missed by mechanically constructed indices based on issue size and/or price. For active managers, who dare to express more conviction and stray away from the benchmarks, this creates more opportunities for alpha generation.

As uncertainty and nervousness are likely to persist in stock markets, convertible bonds offer a compelling middle ground for investors seeking growth potential with a buffer against volatility. On one hand, issuance from companies benefitting from secular growth trends and themes should be good for overall returns.  On the other, an otherwise uncertain and volatile stock market should also mean convertibles deliver better risk-adjusted returns relative to stocks.