Convertible bonds: The best of both worlds?

This article is part of
Alternative Assets - June 2014

While there is always something that can spoil the party nothing is on the market’s radar at present with measures of investor fear, such as the Vix index, at record lows.

This set of circumstances may mean advisers are facing a challenging time getting clients to ease off the accelerator and at least hover over the brake pedal.

So what should advisers consider?

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Among the many ‘alternative’ asset classes are convertible bonds. The securities have been extremely popular among US and European investors for many years but appetite among the UK brethren has been somewhat lacking.

This is potentially strange given that convertible bonds have characteristics of both equities and bonds – staples of UK investors’ portfolios.

Convertible bonds offer characteristics of bonds in the sense that they pay income but they also possess traits of an equity given they can be converted to shares of the issuing company’s stock at the bondholder’s discretion.

Convertible bonds usually offer higher yields than common stock but lower yields than conventional corporate bonds.

The return profile of the asset class supports this.

Data from FE Analytics shows in 10 years the Exane ECI-Euro Convertible index has returned 91.5 per cent in sterling terms, firmly in between the 123.5 per cent return from the MSCI AC World index and 53.2 per cent from the BofAML 1-5 Year Global Government Bond index.

Lee Manzi, convertibles manager at Jupiter Asset Management, said the asset class offered “great risk-adjusted returns”.

“Historically, they have provided equity-like returns (using data for the past 20 years) with considerably less volatility so they can improve the efficient frontier for a portfolio of mixed assets,” he said.

“We think of convertibles as being a ‘conservative equity’ because the correlation is much higher to equities than to fixed income.”

JPMorgan Asset Management’s convertibles manager Anthony Vallee, who runs the group’s recently launched convertibles investment trust, said the yield on institutional mandates he runs is roughly 3.2 per cent at present which “compares favourably with the yield available on traditional fixed income, particularly when you consider the capital appreciation potential”.

RWC’s Davide Basile said convertible bonds “provide the opportunity for investors to participate in any upside move in equity markets while also having the benefit of inherent downside protection.”

The manager added that the securities have a “degree of automatic asset allocation,” which may be useful given strong returns from conventional equity and bond markets.

Mr Basile said the delta – which is the sensitivity to equity – “rises during periods of market strength and declines during periods of market weakness”.

So why is demand in its infancy, relative to other jurisdictions?

Jupiter’s Mr Manzi said the lack of demand in the UK may be down to the fact the UK convertible bond market is “much smaller” compared to Europe and the US.

He added, however, that issuance had been stronger in the past year which was a positive development for the market “as it means a broader choice of securities for investors”.