When we previously discussed the perils of quantitative easing coming to an end in developed markets, we highlighted the relative attractiveness of convertible bonds in a world of rising interest rates and elevated market volatility. While the US continues to roar ahead in terms of economic growth, many markets have been gripped by the developing crisis in emerging markets, escalating global trade tensions and an economic slowdown in China.
Approaching the last quarter of 2018, a broad overview of asset class returns year-to-date shows a clear outperformance of global equities over global fixed income in US dollar terms. When compared to global equities (MSCI World index), convertibles have also inched ahead as the volatile trading conditions of the first quarter and the subsequent world trade-related pressures on Asian and European markets created a more difficult environment for equity investments.
Exhibit 1: Selected asset class returns (%), year-to-date (January to mid-September 2018, in US dollar terms)
Source: Bloomberg, as of September 2018
The period between early 2016, a month after the Federal Reserve first raised US interest rates post the GFC and mid-September 2018, a combination of higher Treasury rates, wider corporate debt spreads and sporadic equity volatility provided an opportunity for global convertible bonds to generate substantially higher risk-adjusted returns because of their embedded optionality and their heavy structural bias to growth.
Exhibit 2: Asset class risk/return (Jan 2016-September 2018)
Source: Bloomberg, as of September 2018
As we appear to be nearing the end of a 10-year equity bull market cycle, the long-proven positive convexity of convertible bonds could allow investors to lock in incremental equity returns, while providing a good buffer to any downside.
Despite this year’s short-lived volatility spikes in global markets, the overall realised volatility of most developed equity indices has remained stable in terms of the 100-day moving average. While not directly comparable to the implied volatility to which investors expose themselves via convertible bond purchases, this measure has had a notable effect on the direction of convertible valuations: bonds have cheapened as volatility has dropped.
While in certain regions and sub-sectors of the global convertible market, the implied-to-realised spread has turned negative given the lack of investor conviction (in emerging markets) or because of poor return expectations, the larger US and European markets have remained attractively priced compared to historical standards. Together, these factors deliver good entry points to investors seeking to diversify their portfolios away from traditional assets, while being paid to carry these positions as higher coupon rates reflect the upward shift in yield curves.
After seeing sequential year-on-year drops in global issuance over the past few years, 2018 is shaping up to be a bumper year for the convertible bond market in the US, possibly contributing to bringing global issuance up to the USD 100 billion mark by year-end. And despite lower rates in Europe and rising risk aversion in emerging markets, 2018 convertible bond issuance in both areas has already surpassed that of the equivalent period in 2017.
Equity valuations continue to be one of the main drivers of issuance in areas such as information technology and involving certain consumer-focused stocks, but with higher Treasury rates and US corporate tax reform, the decline of rapid funding opportunities in parts of the regular debt market has led to renewed interest from companies in issuing convertible bonds.
As investors fret about the decline in liquidity across several asset classes, we would point out that convertible bonds remain liquid in developed markets. While largely a function of credit riskiness, we believe the “moneyness” (delta) of a typical convertible bond and the underlying stock volume and float are good guides to the expected liquidity over time, whereas assets such as standard bonds tend to dislocate faster when faced with bouts of volatility.