Convertibles: normalisation after turbulent years
Convertible bonds have had an extraordinary couple of years against the backdrop of the coronavirus crisis and the subsequent rapid rebound of the equity markets. The high proportion of issuers from the tech sector is strengthening the long-term appeal of this asset class, but active selection is indispensable.
By Carl Fox,
Head of Convertible Bonds at Union Investment
In the convertible bond markets, the last few years have been anything but ordinary. They were dominated by the coronavirus crisis and the subsequent fast-paced recovery of share prices. It would be premature to consider the pandemic completely over and done with, but in light of the breakthroughs in vaccine research and progress with the rollout of vaccination programmes, the capital markets have already priced in a return of economic activity to broadly normal levels. This was reflected in global share price gains of around 24 per cent in euro terms between the end of August 2020 and the end of September 2021 (MSCI World Hedged in EUR).
Convertibles on a positive trajectory
Indexed performance since 1 January 2016
The strong recovery of share prices also boosted convertible bonds, which enjoyed an uplift of about two-thirds of the equity market rebound. In this environment, the valuations of many convertible bonds increased significantly. Looking beyond the superficially very upbeat overall trend, some interesting anomalies catch the eye. Until around mid-February 2021, convertible bonds of technology sector companies recorded bigger gains than the tech-heavy US Nasdaq index. The main drivers of this trend were second-tier mid-cap companies.
In February, a correction among tech sector stocks set in that also had an impact on the associated convertibles. This led to a normalisation of valuation levels. During this phase, the convertible bond market was generally weaker than during the initial recovery from the coronavirus-induced crash in 2020. An active management approach for investments in convertibles paid off over this period. We scaled back our positions in tech paper when valuations went up and then slightly increased them again during the correction.
Big regional differences
The price correction has now created fresh opportunities in the convertible bond market. We currently regard a whole host of paper as attractively valued. However, there are significant regional differences. In relative terms, valuations in the US and Asia (excluding Japan) are more appealing. These regions show a more interesting degree of convexity in the convertibles market than, for example, Europe. Convexity describes the extent to which the prices of convertibles change in response to changes in the underlying share price (convertibles typically participate in share price gains to a greater extent than they are negatively affected by share price falls).
The lower convexity in the European market is partially attributable to the fact that the volume of new issues is lagging behind issuance volumes elsewhere in the world due to a lack of depth and – more importantly – breadth in the pool of growth companies that issue convertible bonds. The markets in the US and Asia (excluding Japan), on the other hand, are seeing a plentiful supply of new paper, which provides favourable conditions for the diversification of convertible bond portfolios. At sectoral level, the tech sector and the medical technology industry continue to offer investment opportunities. And here too, markets in the US and Asia tend to offer more choice. The picture in Europe and Japan looks less promising. Price performance in these regions is likely to lag behind due to factors such as the different weighting of sectors.
China’s strategic political agenda becomes a new factor
Over the summer months, a new topic has caught the attention of the markets. A series of initiatives launched by the Chinese government caused disruption and affected Chinese companies from a broad range of sectors. Beijing’s official position is that these regulatory interventions primarily pursue the objective of ‘common prosperity’, i.e. by reducing social inequality. The initiatives effectively implement a tighter regulatory framework for certain parts of the market and society, for example with regard to fair competition, national security, culture and education.
Following the announcement of government interventions in several sectors, many convertible bonds from Chinese issuers initially suffered heavy losses. This decline was driven by concerns about a significant and irrecoverable loss of profitability. But the implications of these interventions for individual companies need to be assessed on a case-by-case basis. They are not necessarily always devastating across the board. But they are affecting the Chinese convertible bond market, which makes up around 5 per cent of the global market for convertibles, measured by the volume of issues in circulation. American Depositary Receipts (ADRs) representing the shares of major Chinese companies such as Alibaba on US stock exchanges are also impacted, and these make up a further 5 per cent of the global convertibles market.
The new factor of Chinese regulation poses challenges for company analysis that should be considered proactively when analysing any affected issuer. In many cases, companies are already complying with the new requirements in order to mitigate the anticipated impact on their business model to the greatest possible extent. We believe that the brunt of the shock arising from these new regulatory measures for the convertible bonds market is already behind us. Many companies have started to reposition themselves within the changed policy environment. This will create new investment opportunities in the affected sectors over the longer term, although potential risks should be assessed very carefully.
Overall, the market is in a good place
The opportunity/risk profile of the convertibles market as a whole is currently interesting. Favourable valuations, combined with an average equity sensitivity of now 55 per cent, create an attractive level of convexity. Add to that the protection from the bond floor, i.e. the repayment of the bond if it is not converted, and the result is a very promising profile for strategic asset allocation.
We believe that the strong representation of issuers from the US tech sector in the convertible bond market at present constitutes a strategic advantage for this asset class. The growth prospects of many of these companies are positive over a longer-term horizon. But we are also holding on to investments in Chinese companies, because we regard the opportunity to participate in the future development of the Chinese economy as a strategic advantage, although greater variance is to be expected. Active selection will therefore be essential.
As at: 4 October 2021.