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August 2022 | Issue 248

Convertibles head for recovery after six months stuck in gridlock

Dan Alderson
Deputy editor
Having suffered their worst first half on record, convertible bonds are due better performance if only on mean reversion. But various other considerations — including embedded equity optionality, convexity, diversification, lower rates sensitivity, as well as issuer buyback and M&A trends — recommend this as a good entry point for the asset class.
Convertibles had suffered a 20% performance drop from their global average by the end of June.
“Those worst hit are highly correlated,” says Cristina Jarrin, head of convertible bonds at Edmond de Rothschild Asset Management. “Credit and rates accounted for about 50% of the correction, while about 40% came from equities and the remaining 10% from valuation.
“Mid-June brought a complete collapse in expensiveness, and energy being under-represented made overall convertible performance look worse.”
Convertibles have been left below historical averages, with Jefferies estimating their discounts to fair value at 1.5% globally and 3.2% in Europe.
“Those worst hit are highly correlated”
Cristina Jarrin, Head of convertible bonds | Edmond de Rothschild Asset Management
“The repriced profile of the convertible market is a big technical consideration,” says Jarrin. “They are overly discounted, and you should expect normalisation as stock markets improve and credit spreads tighten. They are also a cheap long-term option that is not available elsewhere.”
Yield has returned to convertibles, which are trading close to their bond floors. Jarrin sees opportunities in higher quality companies with good cashflow generation and liquid trading. But she remains cautious on sector concentration of the asset class in areas such as tech, consumer discretionary, and healthcare/biotech.
“They are more like traditional fixed income instruments but still have equity upside,” adds Jarrin. “45% of the US market now trades with a yield to maturity of 8% for just 3.5 years of duration.”
Historically, such dislocations attract new investors to the asset class, given convertibles’ low premium and high delta. They offer convex exposure to sectors less represented in other parts of credit. A shift in investor profile is underway, with ‘tourists’ now making up 20% of participants.
“60% of the convertible market has an equity sensitivity between 40% and 80%,” says Jarrin, “so there is a big pool of opportunities and that means investors can easily find the best convexity.”
Moreover, companies may take advantage by buying back their paper, something already happening in the US and Asia, and starting in Europe.
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Global credit funds & CLO's
August 2022 | Issue 248
Published in London & New York.
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