Time to buy stocks or reallocate to bonds? Do both – with convertible bonds

2022 has so far put investors' nerves to the test. And as always, after a significant sell-off, the same questions come up: Have prices stopped plummeting? Should one get on board now in order to benefit from the recovery? This time, however, equity investors are not the only ones asking these questions, as bond markets have also seen considerable weakness across the board. This has resulted in industry experts referring to the death of the traditional 60:40 (equity/bond) strategic asset allocation. Compared with the corrections of recent years, economic conditions are now much less clear. There are a number of negative scenarios, including recession and stagflation, which have at least a non-negligible likelihood of occurring. This makes decision-making harder with regard to both tactical and strategic asset allocation.

Convertible bonds are an instrument that is ‘designed’ for precisely this kind of environment, as they have what is known as ‘automatic timing’. This means that investors are automatically positioned correctly for both equity market rises and falls without having to actively increase or reduce their equity allocation. On the one hand, convertible bonds participate in the increase in the underlying share price. On the other hand, their reaction to share price losses tends to be more muted. Convertible bonds therefore offer an asymmetric return profile that is particularly pronounced in the ‘sweet spot’ of equity sensitivity, i.e. when their profile is ‘convex’ (balanced).

Depending on investors’ view of the market, they can also invest in either particularly equity-sensitive or bond-like securities in order to profit more from potential price gains or position themselves more defensively. Convertible bonds react very dynamically to market conditions and move quickly from one area to another in terms of equity sensitivity. For example, after the sharp equity market losses during the Covid crisis, the asset class was again able to benefit quickly from the turnaround and recover their losses within a very short period of time, significantly faster than equities, and subsequently continued to make gains. Following the severe market distortions seen so far this year, the average equity sensitivity of the broad convertible bond universe has fallen sharply from around 55% twelve months ago to around 34% now. This means that a large number of convertible bonds are back in the balanced range mentioned above, and therefore present a particularly attractive risk/reward profile.

Convertible bonds offer very specific advantages, but now comes the crucial question: What about performance? Fortunately, it is very robust over the long term, as measured by the Refinitiv Global Vanilla Convertible Bond index, which covers a liquid, global universe of around 560 securities. Since it became available in 1994, equities (measured by the MSCI World index) and convertible bonds have been almost on a par, with performances of 7.4% and 7.3% per annum. However, with just 10.0% p.a., convertible bonds exhibited much lower volatility than equities at 14.9% p.a. (both as of 31 May 2022). In addition, the asymmetric return profile of convertible bonds has been illustrated by the returns achieved, relative to key equity indices, in the year to-date. As referenced below, many corporations appreciate the capital-raising liquidity available through convertible bond issuance, not least those at the cutting-edge of technological innovation. As such, the convertible bond universe has a natural bias towards the Nasdaq as an equity benchmark. In this context, it is interesting to note that the Refinitiv Global Vanilla index has substantially outperformed both the Nasdaq technology index and the broader Russell 2000 Growth index so far this calendar year. The Nasdaq was down 31% and the Russell 2000 Growth lost 32.8% until mid-June, while the Refinitiv Global Vanilla index declined 19% (the MSCI World index was down 22.6%).

Despite a clear bias towards growth names, the convertible bond market includes a wide range of companies from all sectors. Since the pandemic in particular, many companies have rediscovered the advantages of the financing option available through convertible bond issuance when other financing channels were blocked or too expensive. Generally speaking, convertible bonds offer a lot of choice for investors interested in promising segments such as digitisation (including cybersecurity), electric mobility and alternative energy sources. These include companies that have not issued regular corporate bonds. Here, convertible bonds are the only investment option when direct investments in equities are not an option.

Due to the highly uncertain market and economic conditions, we focus on quality when assembling our portfolio. Companies with solid business models and pricing power should provide stability in the event of deterioration in conditions or persistent inflation. This also includes companies that benefit from increasing digitisation and whose supply chains are not affected by the current problems in China as well as the impact of the Ukraine war. In contrast, we avoid companies that react negatively to rising interest rates, e.g. those in the real estate sector, as well as expensively valued and unprofitable growth companies.