Opportunities from adversity in convertible bonds

Every crisis is also an opportunity – this hackneyed saying is probably cold comfort for investors who have suffered steep losses so far this year. But, of course, it is not that simple. The challenge for investors is to recognise an opportunity as such and to act accordingly. And we believe the collapse in growth stocks may now be such an opportunity. Software and online trading stocks, for example have come back down to earth and are now priced far lower. Companies in those sectors are often well-established and profitable – unlike the loss-making hopefuls that were behind the Internet bubble. Of course, timing investments is always a challenge, and the possibility of a further correction cannot be ruled out. This is precisely why convertible bonds can be a sensible alternative to equites, as corrections do not just affect their prices; they also alter the structure of convertible bonds and, in particular, their equity sensitivity (also known as equity exposure), to the investor’s advantage.

 

Many convertible bonds are currently trading in the convex “sweet spot”

This is clear from a comparison between June 2022 and one year earlier. As measured by the Refinitiv Global Vanilla Index, the equity sensitivity of the liquid global convertible bond universe was about 33% at the end of June, down from 55% one year earlier. That means that a very large number of what were then equity-profile CBs are now trading in the convex range. Such CBs have a highly advantageous, asymmetrical risk-reward profile, as they rise more as the underlying shares go up than they fall when the underlying shares go down. What is more, a considerable number of them are now trading with bond-like profiles. Depending on risk appetite and the market outlook, such CBs offer investors an even more defensive profile. Investors can enter at far lower prices while receiving much greater downside protection should the correction not be fully over yet.

 

Growth stocks… with a parachute!

Interestingly, the discrepancies are especially pronounced at the sector level. Consumer discretionaries, IT and communications services, for example, have suffered big losses during the correction. And these are also where the biggest shifts in equity sensitivity have occurred – almost halving in the past 12 months on average, from 62%, 61% and 64%, respectively, to as low as 31%, 35% und 34%. Such growth stocks in particular can now be bought almost with parachutes attached. In recent years, they have very often traded in equity-like territory soon after being issued and became unattractive to many CB investors after losing some of their convexity.

 

Chart: Equity exposures of selected sectors

Source   Refinitiv

 

Greater and greater demand for hacker protection 

Cyber security is one example we see of a structurally promising story against the backdrop of the megatrend of digitalisation. Studies have found that demand for IT security is likely to increase significantly. There are two main drivers of this trend: 1/ the push towards more digitalisation at all levels, including public administrations and medium-sized companies, a trend that was accentuated by the pandemic; network expansion is also increasing the number of potential security gaps and backdoors for attacks; and 2/ political and geostrategic issues have become far more urgent since the outbreak of the Ukrainian conflict. Convertible bonds offer investors a path to IT security companies. The potential of this theme has also been made clear by recent mergers and acquisitions. Many of these were bolt-on acquisitions of specialists by tech companies. For example, Proofpoint was taken over by Thoma Bravo; McAfee divested its B2B business to Symphony; and Google’s parent company Alphabet acquired Mandiant (previously known as FireEye).

We also see selective opportunities in the two other beaten-down sectors of consumer discretionaries and communications services. However, we are more cautious here, due to the uncertain economic environment, with fears of recession, inflation, and rising interest rates. This is the case, for example, in the travel sector, including cruise lines and airlines. Generally speaking, this environment, which currently offers both opportunities and some serious risks, makes convertible bonds an attractive investment proposition, due to their asymmetrical profiles.