Convertible Bonds: opportunity knocks
If we look past negative headlines regarding tariffs and trade wars, the world is currently seeing healthy economic growth and upward pressure on interest rates due to the phasing out of monetary stimulus. Such an environment presents a buying opportunity for Convertible Bonds (CBs). CBs’ equity-like characteristics mean they benefit from economic growth while they are only modestly impacted by rising rates because of their low duration, which averages 1.8 years across the asset class.
Analysis* shows that the CB asset class has outperformed equities over the last 20 years with 35% lower volatility, highlighting the potential added value of CBs to investor portfolios. CBs can also be a powerful diversifier within portfolios, due to their high correlation to equities, but limited correlation to high yield bonds and even negative correlation with government bonds. The analysis shows that CBs have displayed an 85% correlation with equities over the last 20 years but lower figures of 71% and 39% with high yield and investment grade bonds respectively. They showed a negative correlation of -11% with government bonds.
Jasper van Ingen, Senior Portfolio Manager Convertible Bonds at NN Investment Partners explains: “Equities’ and CBs’ outperformance of fixed income in a rising rate environment is a fairly consistent pattern dating back to the 1980s. In times of rising rates, equities have historically performed well as interest rates have risen to counter economic overheating, thereby boosting CB returns. At the same time, CBs are less affected by rising rates than non-convertible bonds due to their lower duration. Rising rates also provide a strong incentive for companies to issue CBs as the coupon rebate that issuers receive becomes more material. This also gives more choice to investors. As such the strong positive momentum in global CB issuance in 2018, the highest since 2007, is no surprise.”
At NN Investment Partners, the convertible bond investment team uses a theme-based framework to identify attractive medium-term investment opportunities. At present, Van Ingen sees several key themes offering outstanding potential in the CB market, including Electronic Components, Healthcare Spending and Cloud Computing. He believes these themes will benefit from an increasing demand for electronic devices with ever more components to increase their functionality, for healthcare-related services to cater for the increasing population that is capable of affording such services, and for cloud data storage.
“We are closely following a number of events and possible risks in the coming months, including a potential further escalation of the trade war, a resurgence of geopolitical tensions and the US midterm elections in November. As such, it is important to construct a portfolio that can weather market disruptions by selecting CBs with strong credit fundamentals.”
* Source: Bloomberg, NN IP analysis 20 years to 31 July 2018, Thomson Reuters Global Convertible Bond Index, MSCI World, BoAML Global Broad Market Corporate Index, BoAML Global Government Bonds Index, all in USD, hedged after 10/2002
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