Interview with Eric Daniel, Convertible Bond Strategy Manager, by Thierry Callault, Head of Business Development.
What impact have the geopolitical context and the sharp rise in interest rates had on the asset class represented by convertible bonds?
In the space of three years, the world has seen a global pandemic, a war between Russia and Ukraine and now an armed conflict in the Middle East between Israel and Hamas. Against this uncertain and frightening geopolitical backdrop, the central banks (FED and ECB) have embarked on a cycle of rapid and significant interest rate rises in order to combat inflation and put an end to years of accommodative monetary policy. While geopolitical events have had an impact on equity market performance and volatility, the central banks’ paradigm shift created very unfavourable conditions for convertible bonds in 2022 in particular. Indeed, the rise in interest rates, the widening of credit spreads, the fall in equity markets and a slight increase in equity volatility all worked against the asset class, and this lack of decorrelation made 2022 one of the worst years for convertible bonds.
However, despite this backdrop, there are many signs that it is time to take a renewed interest in this asset class as part of a global allocation portfolio.
Can these changes create favourable conditions for convertible bonds?
It is important to note that, historically, convertible bonds have performed well in an environment of high interest rates. In addition, as in the period 1998-2001, cycles of rising short-term interest rates generate an increase in equity volatility, which supports valuations. This asset class is one of the few financial products that allow investors to buy long equity volatility (usually 5 years) at attractive levels. The widening of credit spreads since last year is an attractive entry point and could generate additional performance for the equity component of the bond in the future. The end of the period of zero or even negative interest rates has also led to a return to positive yields and coupons, creating a situation where investors are being ‘paid’ to wait!
Finally, the natural convexity of convertible bonds makes them a particularly attractive solution in the current uncertain geopolitical climate. They allow investors to position themselves in the equity market with a lower risk/volatility budget than a direct equity investment. Convertible bonds can be considered by some as a “defensive equity” position.
Why will the primary market for convertible bonds play an important role over the next few years?
Investors have come to terms with the fact that the fight against inflation means that interest rates will be kept at high levels for a long time.
There are many reasons why companies should issue a convertible bond.
Issuing a convertible bond with a 5-year maturity means that the company is making a capital increase deferred over time (5 years) and at a price corresponding to the current share price plus a premium. This enables the company to monetise the volatility of its share price and, above all, to save on financial costs thanks to a lower coupon than a conventional bond.
Companies, which have benefited in the past from the possibility of refinancing at extremely attractive or even zero rates, will have to face a refinancing wall from 2024 onwards. Clearly, the primary market for convertible bonds will benefit from the refinancing of the USD 784 billion of debt expected until 2026. Already, 2023 is a much better year than 2022, and above all, the terms and pricing of new issues have adjusted to the new environment, with the majority of issues priced below their theoretical value.
How can investors incorporate convertible bonds into their allocation portfolios?
Including an investment in convertible bonds has a number of advantages for investors.
The convexity of this financial product makes it possible to improve the risk-return profile of an overall portfolio. Current financial conditions provide an entry point to benefit from future easing of interest rates, a potential narrowing of corporate credit spreads, an upturn in the markets and equity volatility.
All these factors will make it more attractive. This opportunity arises against a backdrop of pricing at a discount to its theoretical value, with yields/coupon returning to positive territory and no market timing.