Adapting Mortgages - Thriving in Times of Transition
In a year marked by economic uncertainty and unprecedented financial challenges, one asset class stood out as a beacon of resilience and growth - convertible bonds.
These hybrid securities, often known as "wandels" or "convertibles," have gained significant attention, with many issuances significantly oversubscribed in 2020. According to Scope Analysis, this underappreciated asset class has shown long-term performance that resembles that of stocks but with lower volatility.
The total volume of all outstanding convertibles increased from around 400 billion US dollars in the previous year to over 500 billion US dollars in 2020. This growth was largely due to the enormous financing needs of companies during the COVID-19 crisis. The year 2020 saw a 13-year high in new issuances of convertible bonds, with a volume of approximately 159 billion US dollars worldwide, which is the highest level of new issuances since 2007.
Convertible bonds took the challenging question of market timing off investors' hands in 2020. Despite massive global GDP declines, defaults on convertible bonds were few. In fact, convertible bonds outperformed corporate bonds, stocks, and high-yield bonds, achieving a gain of 21.5% (Refinitiv Global Focus Convertible Bond Index EUR hedged).
The appeal of convertible bonds lies in their ability to offer equity-like long-term returns with lower volatility compared to stocks, while providing income and capital preservation features not typically found in common corporate bonds or pure equities.
Key performance and advantages of convertible bonds compared to corporate bonds, stocks, and other bonds include:
- Equity-like returns with reduced risk: Over a 35-year period, US convertible bonds have produced returns comparable to equities but with lower price volatility, helping investors capture market upside while cushioning downside risk during declines.
- Income generation with potential for capital appreciation: Convertibles pay coupons like traditional bonds, although typically at lower rates than straight corporate bonds. However, this income often exceeds common stock dividends. The embedded option to convert into equity offers upside potential beyond fixed income instruments.
- Asymmetric risk/reward profile: Convertible bonds offer a convexity advantage; investors participate in equity price rises but have protection from principal loss due to bond floor value, unlike common stocks. At maturity, the investor can redeem at the higher of the bond’s face value or its conversion value.
- Lower sensitivity to interest rate changes than many bonds: Convertibles are less sensitive to rising interest rates compared to straight bonds, due to their equity conversion feature, which provides a cushion when bond prices fall.
- Greater portfolio diversification and risk-adjusted returns: The hybrid nature of convertibles helps smooth returns relative to pure equity or bond portfolios, improving overall risk-adjusted performance.
- Active management can enhance outcomes: Due to their complexity and varied structural features, expert security selection and ongoing management are critical to optimizing returns and managing embedded risks.
- Flexibility and accessibility for issuers: From the issuer’s perspective, convertible bonds are a strategic financing tool offering lower-cost capital than straight debt and less dilution than equity, supporting continued demand for convertibles and expanding their market.
In summary, convertible bonds can be viewed as a middle ground between corporate bonds and stocks, generating equity-like growth with bond-like stability and income. They are attractive for investors seeking balanced long-term performance with downside protection.
As more bond investors turn to convertible bonds due to low or negative interest rates on the classic bond market, it seems that this underappreciated asset class is poised for continued growth and recognition in the years to come.
[1] Scope Analysis [2] Investment Management Association [3] Financial Times [4] McKinsey & Company [5] BlackRock
In light of the increased interest from investors seeking balanced long-term performance with downside protection, the business of investing in convertible bonds could potentially expand, given the underappreciation of this asset class highlighted by various financial sources such as Scope Analysis, Investment Management Association, Financial Times, McKinsey & Company, and BlackRock. As other finance professionals reassess their investment strategies due to low or negative interest rates on traditional bonds, it's possible that convertible bonds will see increased adoption in various businesses for their equity-like returns with reduced risk.
