2022 was the worst year since 2008 for the Convertible Bond asset class. None of the pillars of the asset class helped. We experienced a sharp rise in interest rates to fight global inflation which marked the end of a lengthy interest rate bull market. Corporates credit spreads widened significantly, and equity markets all closed with a negative performance for the year. Even equity volatility, despite having changed regime, was not very supportive with most volatility trading between 20 and 30 level with some spike in Europe in March due to the war in Ukraine.
What could we expect for 2023?
Let’s analyse what could be a source of optimism for the asset class:
- With interest rate hikes, we could expect the primary market activity to return to normality in 2023. Historically, corporates prefer to issue convertible bonds rather than classic straight bonds due to the perks of a lower coupon payment. We already noted that since last November, new convertible bond deals are issued at discount to fair value which represent a reliable source of alpha for investors. After a disappointing 2022 year for the primary market and a significant maturity wall in 2023, corporates will be encouraged to use the convertible bond asset class to access capital. This should represent opportunities for investors to consider those new issuances as a replacement for holdings that have become too bond-like after the 2022 slump.
- With corporate credit spreads having widened during 2022, coupons and yields have turned positive, improving the asset class prospects. Thus, buying convertible bonds with positive yields allows investors to be paid to wait for better times and in the case of an improvement in the corporate financial situation, expect a tightening of the credit spreads which will contribute to the performance of the investment.
- As earnings revisions are expected in 2023 in a recessionary environment, being invested in convertible bonds allow investors to be exposed to the equity market with a low risk and volatility budget. After 2022, the convertible universe delta has significantly repriced and should provide some protection against potential equity shocks. Having a discounted convertible bond universe represents a compelling investment opportunity and the convexity of the asset class should play its role in a global allocation.
- Additional to the above points, we noted a resurgence in M&A activity amongst issuers of convertible bonds, and this could provide not only interesting support on the downside but also a source of performance for investors.
- Finally, since September 2022, we noted a growing interest from institutional investors regarding the asset class and we could expect 2023 to be the year of a return of inflows to the asset class.
What is our positioning?
We continue to favour the United States as the main convertible bond market in the world, although as a global fund – we also have the opportunity to add tactical exposure to the likes of Japan and China and indirectly to emerging markets through quality names in Europe and the United States. Additionally, we remain defensively positioned compared to a traditional equity portfolio, given the hybrid nature of convertible bonds that provides us bond like protection on the downside and equity like participation on the upside.
We view the weakness in 2022 in the United States as an opportunity that shouldn’t be missed, with some profitable technology companies down more than 60%, offering attractive buying opportunities. While we agree with the consensus that there may be some weakness in the first half of the year, we think there is a strong likelihood of a subsequent and strong recovery going into the second half of the year. That said, we remain selective and believe that enhanced due diligence and careful stock picking will remain key to a successful 2023. Elsewhere, in the first quarter of the year, we believe that China may offer some tactical reopening opportunities as the country begins to reopen following an almost three-year lockdown period although we remain cautious given the potential for a stop-start reopening. In Japan, we continue to like the undervalued, highly profitable companies, across a wide variety of sectors. Finally, in Europe, we remain cautious given the energy crisis caused by the Russia/Ukraine war and the subsequent rampant inflation and borrowing costs.
Conclusion
Investing in convertible bonds for investors represents an opportunity to be exposed to the global equity market with a lower risk budget than a direct equity investment, an opportunity to get some positive yield coming from the coupon payment, an opportunity to benefit from credit spread tightening and an opportunity to add convexity and diversification into portfolios.