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Can convertible bonds shine amid uncertain markets?

Photo of Xavier Linsenmaier

By Xavier Linsenmaier and Brinda Kirpalani, Co-Portfolio Managers, New Capital Global Convertible Bond Fund

The worst of the pandemic may be over, but the reality is that elevated market volatility is likely to remain in place for the foreseeable future.

Whether it’s the knock-on impact of the Ukraine conflict or the uncertainty stemming from rapidly rising inflation and rates, it seems the upside potential on offer across equity and credit markets will be more than matched by potential downside risk for some time.

In turbulent periods like this, investors need options but it’s not always easy gliding from one asset class to another without potentially mistiming markets or risking having capital eroded by fees.  Sometimes overlooked, Convertible Bonds can help mitigate these issues and present investors with an excellent opportunity to position for all eventualities.

Best of both worlds

A convertible bond is essentially a corporate bond that can be converted when deemed necessary or advantageous by its holder into a specified number of shares in the issuing company.

There’s a wide variety of reasons why the instruments exist.

For issuing companies, a major benefit is the fact that they typically carry lower interest rate payments than regular corporate bonds. Investors are willing to accept this because they can benefit from a rise in valuation through conversion, and the savings for issuers themselves can end up being very significant.

Another attraction is the fact that convertible bonds can be used to raise money with far less immediate dilution than an equity-only raise. This, of course, can be a great way of managing investor sentiment. Equally, the main benefit of convertible bonds for investors is their unique mix of equity like performance and bond-like protection.

How do they achieve this?

Put simply, should the value of Company X dive, a convertible bond issued by that company will not decline in value to anywhere near the same extent as its equity will, because it is protected by what is known as the “bond floor”. Barring a situation of default where the issuer is incapable of meeting its debt obligations, theoretically the value of the convertible is supported by the par value at which the bond would be reimbursed at date of maturity.

Conversely, should company X rise, the closer its share price gets to the convertible bond’s conversion price, the more the value of that convertible bond will mirror the share price until they eventually behave in the same way. This sort of upside participation stands in stark contrast to corporate bonds, whose value is fixed at issuance.

Supportive outlook

A range of tail risks have emerged in recent months to upstage what was to be a resilient growth backdrop and are positioned to keep markets volatile.

Chiefly, while there was evidence of global supply chain recovery post Omicron, there has now been evidence of some setback after the Russian invasion of Ukraine.

The conflict has not abated despite mounting sanctions, and investors have become highly concerned over the long-term impact on international order and the global economy. With China also slowing on Covid lockdowns investors regard a global recession as the most important macro risk for markets, followed by hawkish central banks and inflation.

Not only are all the above factors creating sizeable risk aversion, but they are also directly and indirectly impacting every single commodity–whether its energy, metals, or food.

We believe that in the medium to long term, convertible bonds are well suited to manage these headwinds.

As mentioned, their structure allows for upside participation alongside downside protection–the perfect combination when it comes to investing in an ever-changing market. But beyond this, they also offer protection against the fact that, while the war is dominating headlines, we are also set to remain in a rising interest rate environment for some time.

Convertible bonds typically have shorter durations than non-convertible debt to help mitigate the impact of rising interest rates on their valuations. Furthermore, rising rates are also typically associated with economic growth and as such are positive for equities and for equity call option valuations.

Thus, the embedded conversion options in convertible bonds stand to become more valuable, offering investors a way to reduce the volatility of an equity portfolio or increase the expected return of a fixed income portfolio during times of rising rates.

The focus must be kept on quality companies though – those with robust management, market breadth and depth, as well as liquidity.

Continued market volatility is a given for 2022, but we believe the asymmetrical nature of convertible bonds could help investors looking to absorb market downsides while getting exposure to the upside.

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