Investment or arbitrage? Both, with convertible bonds

Convertible bonds offer an asymmetric yield profile that benefits from the best sensitivity to equity due to a balanced profile called a “convex”.

So far, 2022 has tested the nerves of investors. And as always, after a pronounced correction, the same questions return: is the downward movement over? Is it worth investing now to reap the benefits of a future rebound? However, this time these issues concern not only equity investors, but also those who operate in the bond markets, which have also undergone widespread correction. But compared to the recessions of previous years, the economic situation has become much more uncertain. Certain adverse scenarios, including recession or stagflation, are unlikely to occur. These considerations significantly complicate asset allocation decisions, both tactically and strategically.

Convertible bonds are instruments that are ideal for this type of context because they have a so-called automatic “timing”: whether the stock markets are bullish or bearish, investors are systematically well positioned, without the need to actively increase or decrease their equity. contact. Indeed, on the one hand, convertible bonds are involved in rising stock prices, but on the other hand, the decline in stock prices has only a moderate effect on them. Thus, convertible bonds offer an asymmetric yield profile that provides the best stock sensitivity due to a balanced profile known as “convex”.

Depending on its market valuation, the investor may choose securities that are either particularly sensitive to equities, or, conversely, closer to bonds, and thus obtain a larger and more targeted return on potential equity gains, or adopt a more defensive position. Thus, convertible bonds respond very dynamically to the market environment and move quickly from one state to another in terms of sensitivity to stock market movements. For example, after a sharp drop in stocks during the Covid crisis, the asset class quickly took advantage of the rebound and was able to erase its losses in the shortest possible time, recovering much faster than stocks to close even higher. After this year’s marked turbulence, the global world of convertible bonds represented an average stock sensitivity of about 34%, down sharply from 55% recorded 12 months earlier. A very large number of securities behave in a balanced way and offer a particularly attractive profile of opportunities / risks in this regard.

Thus, convertible bonds offer very specific benefits – now we need to answer the crucial question: what about their effectiveness? According to the Refinitiv Global Vanilla Index, which covers nearly 560 liquid convertible bonds worldwide, this is great in the long run. Since the launch of the asset class in 1994, convertible bonds have shown a performance of 7.3% per annum, equivalent to equities (7.4% per annum for the MSCI World Index), and significantly lower volatility: 10.0% per annum for convertible bonds. bonds, compared to 14.9% for shares (as of May 31, 2022). In the short term, until 2022, convertible bonds, at first glance, did not show good results, as they suffered similar losses as other broad indices. This result is due to the significant representation of growth sectors in the universe of convertible bonds, and the latter were the subject of much higher sales than others. But a comparison of mid-June to the US Nasdaq (-31%) or Russell 2000 Growth (-32.8%) index favors convertible bonds backed by the exemplary characteristics we just mentioned: the Refinitiv Global Vanilla index lost only 19 % (-22.6% for MSCI World).

Despite a significant bias towards growth sectors, the convertible bond market contains a wide range of other areas of activity. The pandemic particularly revealed the benefits of this asset class to many companies, which then faced paralysis or an increase in the value of other funding channels. Convertible bonds give investors access to promising sectors such as digital transformation (including cybersecurity), electric mobility and alternative energy. Among these profiles are companies that do not issue other types of bonds and are therefore only available through convertible securities due to the inability to invest directly in their shares.

Given the deep uncertainty of the economic climate and market conditions, quality, in our opinion, is an important aspect in building portfolios. Companies with sound business models and pricing must offer stability in the event of a downturn or sustained inflation. It also includes companies that benefit from the growth of the digital transformation and whose supply chains are not affected by the current problems in China or the effects of the war in Ukraine. Conversely, we avoid companies that respond poorly to rate increases, such as the real estate sector, as well as highly valued and unprofitable growing companies.