Executive summary
We find that the convertible market offers a compelling way to earn equity returns with bond-like protection from corners of the broader markets that might otherwise seem too terrifying; for example, US growth stocks and Asian equities. Following record levels of issuance in 2020 and 2021, the convertible market is broader and deeper-about 1/3 the size of the global high yield market (sources: Bloomberg and Refinitiv). Recent market pullbacks mean that some formerly equity-sensitive convertibles have become more balanced and now offer strong ratios of upside participation versus downside risk, and from which we can rebase single-name exposure and build differentiated portfolios. With rates seemingly on the rise, that bond protection comes with a comparatively short duration profile of about 2-3 years, which means less pain if yields increase. Finally, in an environment of heightened volatility, we think the value from the embedded optionality of convertible bonds may increase and potentially prove especially useful as a source of diversification for a multi-asset portfolio.
How we look at the world day to day
Before we give our review of the year just past and outlook for the year ahead, we present a short summary of the portfolio construction process for our convertible bond funds.
The convertible bond market is constantly changing. As stock prices move and time marches forward, options to convert into shares can gain or lose equity sensitivity, maturity dates draw nearer, and issuance of convertible bonds can add new investment opportunities into the market.
We do look at individual investment cases and the moving parts of the broader market to see how companies’ share price could move on their own and in relation to each other. And for some of our investment cases, we also consider ESG profiles and the sustainability of issuers.
But our day-to-day activity is often focused on looking at convertible structures that provide meaningful upside but also strong downside protection. As markets and individual stock prices move, we can redeploy capital as convertible structures change in profile.
These moves allow us to shift our portfolios to provide exposure to return potential where we are getting compensated for risk, and to avoid risks that we don’t want. In sum, using convertible structures and an understanding of investment cases can lead to convexity, or the possibility that we can earn more from moves up compared with the risk taken from an equal move down in an underlying stock price.
What happened in 2021
Following a year of stunning relative returns in 2020, convertible bonds struggled to match that performance in 2021. There were a few reasons arguably behind these weaker relative returns.
First, performance of equity markets was dominated by a handful of large mega-cap names, and none of these companies had issued convertible bonds. As an example, the NASDAQ returned approximately 23% in 2021, where the top 6 names (out of more than 1000) delivered a 15% return[1]. Second, the global convertible bond market had a regional skew towards Asia compared with broader MSCI indices, and that tilt was a drag as Asian markets suffered in the first half of the year. Third, many convertible issuers are more growth-focused, such as software companies. Some of these stocks saw dramatic reversals in their share prices in 2021, and without much exposure to stocks that performed relatively well in the year such as financials and energy, these growth stocks were a detractor to relative performance. Finally, volatility was generally muted in 2021 and convertible valuations cheapened, which were headwinds compared with 2020, when rising volatility created a more favourable environment for convertible bonds.
How does the market look for 2022?
Without claiming to know the exact path that markets might take, we do feel that the backdrop is much more conducive to good relative performance from convertible bonds.
Besides the inevitable uncertainty associated with COVID-19, the question that has dominated markets thus far is the future path of interest rates and policy measures from the Fed. Rates have been kept low for long, but if inflation is really here to stay, the Fed will have to hike rates. And the reaction of markets to rising rates has been jittery, to say the least. The implication of higher rates raises issues for growth stocks and long-dated bonds alike, which have been corners of the market where some investors have piled in to find the most exciting returns, or simply to earn yield.
That said, the pullback in stock prices that began at the end of 2021 has caused some interesting changes to convertible profiles. We have been redeploying our portfolios into convertibles where we know the investment cases well and now trade at lower cash prices. For example, we have been adding back convertible bonds issued by Square—now known as Block—that are now trading at a far more balanced level of equity sensitivity. At the same time, we are trimming names that are on their bond floors and offer minimal upside and are reducing risk from selling down winners that have high degrees of equity-sensitivity. After making these moves, we believe that our portfolios should provide good levels of convexity.
Indeed, in a more volatile market, convertible bonds are a good way to keep exposure to stocks without having to take their full downside. The optionality provided by convertible bonds becomes more valuable as volatility increases. Intuitively, this relationship of volatility and value makes sense when considering that the option provides a floor if an underlying stock loses value but can quickly gain in sensitivity if that stock were to move sharply higher.
Bond investors who are struggling with the implications of higher rates should take comfort in knowing that convertible bonds are short duration by nature. We have made moves to further reduce this risk in our portfolios. While we cannot completely the eliminate headwinds created by duration, we do see that convertible bonds may suffer far less than long-dated bonds from rising rates. We also see that credit has remained stable since 2021, with government support for the economy still strong unlikely to change as COVID-19 has not gone away.
Finally, following record levels of issuance, the convertible bond market as it stands today is broader and offers the possibility to build a diversified global portfolio. Following issuance of more than $150 billion in both 2020 and 2021, the convertible market now totals about $660bn globally, which we estimate is about 1/3 the size of the global high yield market (source Refinitiv and Bloomberg). The last time we saw issuance this high was in 2007 ($224bn). Do we expect the same level of issuance in 2022? That depends on how events play out and whether any weakness in stock prices is offset by the impact of financing bonds at higher rates, which can make convertible bonds look more attractive to an issuer.
Past performance is not a guide to future results. The prices of investments and income from them may fall as well as rise and an investor’s investment is subject to potential loss, in whole or in part.
No investment strategy or risk management technique can guarantee returns or eliminate risks in any market environment.
Forecasts and estimates are based upon subjective assumptions about circumstances and events that may not yet have taken place and may never do so.
[1] Source: Bloomberg, as at January 31st 2022
