I recently wrote about convertible bonds as a good way for a multi-asset portfolio to stay on course in choppy markets because their return profile has typically provided upside capture, while protecting on the downside. A few months on, the case for convertibles is just as strong.
In the 2000-2002 bear market, equities lost 45 per cent, while convertibles only lost 25 per cent – both on a total return basis. In the 2007-2009 global financial crisis, equities fell by 50 per cent, but convertibles fell by just 36 per cent. In the bull market from 1993-2000, developed market equities gained 174 per cent, while convertibles increased 152 per cent. From 2002-2007, equities rallied 123 per cent, while convertibles rallied 80 per cent. And in the current market cycle since 2009, equities have made 171 per cent, while convertibles have risen 112 per cent.
At a time when diversification is more important than ever, exposure to a wide range of issuers can also give investors an edge when it comes to managing risk and gain returns.
The market is diversified across a broad variety of issuers from a range of sectors and countries. The asset class is traditionally associated with growth companies that have issued convertibles to finance their future expansion, and the market’s relative bias towards the technology sector shows this very clearly. Growth companies come with the potential to deliver significant capital return, and the in-built downside protection of convertibles makes them an attractive asset class via which to access these companies.
Sectors: The convertibles market is more exposed to cyclical sectors, and exposure to companies with improving fundamentals provides attractive opportunities for capital gains. That said, all major sectors are represented within the convertibles market, and convertible bonds issued by stable/mature companies within defensive or financial sectors help to generate stable returns over time while contributing to the income-generating characteristics of the market. On the other hand, financial companies within the MSCI AC World Index are predominantly banks, insurance, and real estate companies, which represent the biggest financial issuers of convertible bonds.
Size: The convertibles market is also highly exposed to companies within the small and mid-cap space, as shown in this week’s chart. This concentration arguably leaves the convertible bond market well-positioned to benefit from a pick-up in mergers and acquisitions (M&A), since small and mid-cap companies are frequent targets for M&A activity.
Geographies: The global convertibles market offers regional exposure similar to that of the MSCI AC World Index. However, there are notable differences within each region. In Europe the convertible bond market has greater exposure to eurozone countries such as France, Germany, Portugal, Spain and Italy, whereas the MSCI AC World Index has a greater weighting in Switzerland and the UK. In Asia, the convertible bond market provides investors with higher exposure to China and Singapore, while the MSCI AC World Index is more heavily weighted towards Australia and South Korea.
There is a significant divergence in profiles on a region-by-region basis in the convertible bond market. US convertibles continue to be the most equity-sensitive region and the recent strong performance of US equities has led to an increase in the overall average price of securities. Europe offers opportunities for balanced equity exposure, but with less significant representation from small and mid-cap issuers. Meanwhile, Asian convertible bonds tend to exhibit less equity sensitivity than other regions following a prolonged period of weak equity performance, but higher average yields compensate for this. The Japanese market is characterised by a significant weight in investment-grade issuers, but the convention of issuing convertibles with a zero coupon leads many Japanese convertibles to trade with a negative yield. This dispersion of regional profiles suggests that a global portfolio is required in order to build a truly diversified and balanced portfolio that combines opportunities for both equity participation and yield generation.
Nandini Ramakrishnan is global market strategist for JP Morgan Asset Management
