Investment Insight – Convertible Bonds

By M. Isi Eromosele

Against a backdrop of significant macro uncertainty arising primarily from the European debt crisis and from election year related public policy uncertainty in the United States, convertibles are well poised to provide risk-adjusted equity exposure with adequate income. They are attractive as both a portfolio hedge and as a standalone investment.

United States GDP growth slowed in 2012 as the European financial crisis, U.S. legislative gridlock, the persistently weak housing market and sustained elevated unemployment weighed on consumer confidence and consumer spending.

These factors are expected to persist and while there could be cautious optimism that they should improve later this year, this is by no means certain. Given this potentially volatile economic backdrop, the convertible bond sector may be considered a risk-adjusted avenue to gaining exposure to the equity market.

Well Balanced | Attractively Valued

Globally, equity declines and widening spreads in 2012 have made the convertible asset class much more defensive. Currently, most convertible bonds in the market have balanced profiles, with prices centered near par and above average yields.

U.S. convertibles currently have an effective equity exposure of 43 percent. The relatively short duration of the market is also attractive in the context of a policy driven low interest rate environment.

Additionally, the asset class has clearly cheapened relative to both equities and fixed income, making valuations attractive at current levels in our analysis. The convertible market was trading rich just before the summer of 2011, but subsequent market declines have brought valuations down to reasonable levels.

Looking Into The Future

For the remainder of 2012, the U.S. convertible returns will be driven by a combination of reasonable income, modest equity driven appreciation and some improvement in valuations. Their base case return expectation is 7%, making convertibles a potentially attractive risk-adjusted investment relative to high yield, investment grade credit, equities and U.S. Treasuries.

Underlying assumptions are an equity price rally of 6 percent, total equity returns of 8 percent, spread tightening of 20 bp (investment grade) and 50 bp (high yield) aswell as zero defaults of investment grade paper and a high yield default rate of 0.7 percent.

Multi-Level Diversification

The composition of the buyer base remains healthy with a more balanced mix of investors. The market has vastly improved since the dark market days of 2008.  Long-only convertible managers and cross-over buyers (equity and income funds, high yield bond funds, and investment grade bond funds) have become a much bigger part of the market.

This has created a more broad/diverse ownership base and increased stability of the asset class. This is evident as liquidity in the convertible market has been good through the highs and lows of 2011 into 2012.

Additionally, the convertible market is composed of a broad spectrum of security profiles, credit qualities, market caps and structures, making it a promising avenue to gain portfolio diversification.

Convertibles In A Multi-Asset Portfolio

Convertibles are a dynamic asset class and as such, there are different ways that investors can use them to pursue their asset allocation goals.

Convertibles may be considered a “defensive equity” approach which could mitigate the need to make an equity timing decision because of the following potential advantages over straight equity:

• Yield advantage - convertibles have historically provided a yield advantage over equities. In addition, convertibles are senior to equities in the capital structure.
• Asymmetric return profile - over various market cycles, convertibles have historically captured more of the equity market’s upside due to their embedded call option while providing downside protection due to the bond floor.
• Historically attractive risk-adjusted returns - convertibles have outperformed equities over various time periods with substantially less volatility. They exhibit higher Sharpe ratios, which show how much excess return is being generated for each unit of risk utilized.

Convertibles can also be considered as an “equity kicker” for those investors looking to diversify their fixed income allocations. Investors can potentially add alpha by sacrificing a certain amount of yield to obtain some equity exposure.

Lower Interest Rate Risk

Due to their put/call features, convertibles historically have shorter durations relative to traditional fixed income bonds. With interest rates at their all-time lows, investors are concerned about the impending impact of rising interest rates.

While convertibles are influenced to a degree by interest-rate fluctuations, they are also impacted by the price movements of their underlying stocks, a factor that has tended to soften the negative effect of rising interest rates.

Compared to both the corporate high yield and the aggregate markets, which range between 4 and 4.5 years in duration, the convertibles market has tended to be for short duration at about 2 years.

Better Risk-Return Profile

Convertibles may improve the risk/return profile of stock/bond portfolios. Historically, adding convertibles to a stock and bond portfolio has “pushed out” the efficient frontier, i.e. creating a portfolio that achieved a higher return with the same level of risk.

A Distinct Asset Class

Over time, convertibles can be used as a separate and distinct asset class due to their historical risk/reward profile and low correlation to straight equities and fixed income.

Overall, 2012 will likely be a good year for convertible bonds. Nevertheless, avoiding issue specific underperformers will be the key to performing well. This will prove to be even more important than picking the issue specific winners, given the asymmetric risks that are present in the market.

Additionally, making good relative value, security selection, tactical sector rotation, primary market cheapness and event driven opportunities will continue to play a significant role in the generation of alpha.

M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance

Copyright Control © 2012 Oseme Group