After a challenging year for all asset classes, conditions in the New Year are shaping up to be less volatile. Written by Xavier Linsenmaier, CFA, Co-Portfolio Manager, New Capital Global Convertible Bond Fund.
There were few places for investors to hide in 2022, but just like in other asset classes, energy provided some shelter.
With equities falling and bond prices dropping in tandem, the convertible bond market was challenged just like its conventional stock and bond peers.
But while 2022 was a challenging year, it looks like 2023 will see a rebound in convertible bond issuance. Higher rates and credit spreads makes convertibles a potentially attractive proposition for bond issuers to reduce financing costs. We expect the share of investment grade issuers to raise from a low mark.
This should lead to less challenging conditions for Convertible Bond funds, although there will inevitably be issues to navigate.
The energy sector didn’t feature heavily in the convertible bond ecosystem in 2022, but one of the leading companies, who has the monopoly on the tank technology needed for vessels to transport liquefied natural gas (LNG), was one of the best performers in 2022.
More broadly in Materials sector, one of Turkey’s leading companies benefited from the onshoring of production away from historically cheap Asian markets, as central Europe apparel firms sought to secure their supply chain closer to home.
Although energy was a compelling sector to have exposure to in 2022, we expect there to be a broader cohort of opportunity in 2023.
After two record-breaking years of issuance in 2020 and 2021, with 159bn$ and 148bn$ convertible bonds issued, respectively, the number of available new offers in 2022 dropped precipitously to just under 40bn$ (BoAML, as at 31/12/2022).
However, there are now expectations that this could almost double to 75, according to Bank of America.
This increased issuance should add to the already satisfactory levels of liquidity in the market and encourage more new investors into the space.
That in turn should see the convertible bond market’s spread premium tighten, meaning that prices rise, thus bolstering returns.
The average implied credit spread of the convertible bond market has widened in 2022 as investors decided to exit the asset class due to redemptions and a more risk-off investment approach. Non-traditional convertible bond investors (e.g., fixed income funds) didn’t have the capacity to step in, despite its attractiveness.
As a consequence, the number of low delta convertible bonds in our universe, which are trading at dislocated values compared to their fixed-income peers and the CDS market, has increased significantly. The average duration of the outstanding convertible bonds is rather short, partly due to a lack of new issuance in 2022 and embedded PUT features, which could be a catalyst for performance in 2023. From a valuation point of view, the asset class remains cheap, especially in the regions Asia-ex and Europe. Nevertheless, there will inevitably be challenges that the market faces, and as a result, sectors that investors may want to avoid.
Alert to risk
There is a growing consensus that the US Federal Reserve may not have to raise rates as much as previously predicted, as fears about inflation recede and commentators increasingly expect any possible recession to be shallower than they previously thought.
But if this narrative is upset, and policymakers in the US do have to raise rates more than currently expected, then that could have major ramifications for the market.
Linked to this is another factor that investors should be aware of – bond vigilantes.
With huge levels of sovereign debt accumulated by nations around the world as part of efforts to overcome the Covid-19 pandemic, there is a very real possibility that bond vigilantes could challenge central banks in relation to their financing needs.
The spread that is being offered for the likes of Chinese hotel names is too large, in our view, while we are also significantly underweight in cruises, something that makes up a large part of our benchmark.
Essentially, we are likely to be extremely selective when considering businesses that rely on discretionary spending given the continued uncertainty within the global economy.
As for 2023, macro divergence between record interest rate curve inversion and high employment creations makes the asymmetrical nature of the asset class an asset. For illustration, US convertible bonds – which make up the largest proportion of our benchmark and our fund – have produced a higher annualised return than either a 60/40 equity-bond or bond-equity portfolio, this should provide investors with a level of confidence.
Data from Bloomberg shows that US convertible bonds have delivered a 7.2 per cent annualised return between 2007 and 2022, compared to the 60/40 equity-bond’s 6.8 per cent, and the 60/40 bond-equity’s 5.6 per cent.
To summarise, we believe that 2023 is shaping up to be a steady and constructive year in the realm of convertible bonds.