InvestmentsJun 23 2014

Convertible bonds: The best of both worlds?

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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?

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”.

The reasons for the weak demand may also be the availability of products to UK investors.

The fund search function on FE Analytics shows just four open-ended convertible bond funds are based in the UK while there are 63 offshore funds available to UK investors.

These are largely from European groups such as Amundi, Mirabaud and UBS, however, several UK groups, such as Schroders and Aviva Investors, have products within their offshore ranges.

Functional issues such as platforms only more recently becoming sophisticated enough to hold offshore funds and advisers’ home bias and thus preference for something based in the UK may also have been a headwind.

But appetite must be improving.

JPMorgan Asset Management last year launched its Global Convertibles Income Fund investment trust, which was the largest ever capital raise in the company’s history.

Given JPMAM has 26 investment trusts, this is something of a landmark.

RWC’s Mr Basile said new issuance had “continued to gather pace” this year with year-to-date issuance as at May 31 standing at $37.9bn (£22.2bn) against $35.9bn for the comparable period in 2013.

He added June had been “significantly stronger than the previous months” and he expected this year’s total to beat that of 2013.

“Issuance has been robust on the back of the strong equity rally, merger and acquisition trends, small-medium sized companies’ growth capital raisings and share buybacks,” Mr Basile said.

“We expect these trends to continue to drive issuance, and the expectation of higher rates is likely to provide another catalyst to converts issuance.

“Additionally issuance has been broadly diversified across sectors and regions as companies globally see the benefits of the asset class as a tool for raising capital.”

For advisers considering convertible bonds for their clients, their question will inevitably be where do they fit into a portfolio?

JPMAM’s Mr Vallee said this is “very much determined by how investors classify their objective in holding these securities”.

“If you’re buying convertible bonds primarily for the capital appreciation potential with the income objective as a secondary goal, then you could categorise convertible bonds as an equity alternative,” he said.

“On the other hand, if you’re buying convertibles primarily for the income with the potential for growth as a secondary goal, then you could consider convertibles in the bonds part of your portfolio and classify them as extended fixed income strategies along the spectrum of high yield debt or emerging markets debt.”

RWC’s Mr Basile said convertible bonds had the benefit of reducing the duration of bond portfolios.

Duration is the sensitivity of a bond or portfolio of bonds to rises in interest rates. Seeing as western interest rates will rise from current low levels, a lower duration could be beneficial.

The IMA classifies convertible bonds as equity and Mr Basile said convertible bonds could act as “conservative equity exposure” especially at a time when “investors are starting to get worried about the market levels and want to de-risk their equity portfolios”.

Mr Valle said “typical buyers” of convertible bonds tended to be wealth managers, private banks and institutional investors. He said these investors liked the fact convertible bonds offer “equity-like returns with about half the volatility of equities”.

Given the point of the cycle in the market, convertible bonds may have their place in a portfolio now.

Mr Valle said prior to the financial crisis there was a “limit to investor appetite due to the so-called ‘opportunity cost’”.

“By this we mean that because convertibles offered a relatively lower yield compared to other fixed income instruments, investors expected adequate capital gains in order to be compensated for the lower yields,” he said.

“Now, the ‘opportunity cost’ has nearly gone as the yield available on other instruments has greatly diminished given the low interest rate environment.

“In effect, this has made convertible bonds look very attractive on a relative basis.”

Mr Basile was equally optimistic about the role convertible bonds could play in a portfolio now.

“Demand today remains strong and continues to grow,” he said.

“Valuations are fair, but demand is coming from investors who understand the long term benefits of 60 per cent upside, 30 per cent downside without paying performance fees.

“We expect demand to continue going forward as investors start to rotate out of higher beta asset classes.”