Written by Paulus De Vries, CFA, Co-Portfolio Manager, New Capital Global Convertible Bond Fund
The expected glut of new bonds has failed to materialise meaning that managers must amplify their scrutiny of portfolio risk
Predictions of a resurgence of convertible bond issuance have disappointed so far in 2023, amplifying the importance of security selection.
It’s difficult to know with absolute certainty why prospective convertible issuers might be holding back, but there are two likely narratives.
The first revolves around the trajectory of interest rates in the world’s major economies, which while still rising do now appear to be reaching their peak based on central bank rhetoric.
And the second relates to the improved macroeconomic outlook, whereby predicted recessions are expected to be shorter and shallower than commentators were expecting just six months ago, and unexpectedly buoyant equity markets, with the likes of the UK’s FTSE 100 hitting a record high in mid-February, mean companies are less desperate for cash (and could be more willing to refinance their funding needs by raising equity instead).
With limited new issuance so far this year, the importance of convertible bond fund managers to select the right securities increases, meaning that a clear and methodical process is vital.
After record-breaking convertible bond issuance during the pandemic, with $194 billion in 2020 and $197 billion in 2021, the market dropped off steeply in 2022.
Last year, issuance only surpassed $60 billion yet with predictions that 2023 issuance would start high.1
However, the more doveish remarks from the likes of the Federal Reserve and the Bank of England could be indicating to firms that rates may soon peak as inflation cools.
This could mean that CFOs are hoping to be able to refinance corporate debt or issue new deals at more attractive terms than current conditions allow, even though the environment for convertible debt could be viewed as a more compelling (cheaper) option compared to conventional bonds.
A dearth of issuance can be preferable to an oversupply, whereby deals are too expensive and yields paltry, but it still puts a greater emphasis on the need to identify the optimum securities.
A shift in risk
Besides the obvious and crucial credit and equity selection, one preferred approach involves dividing the convertible bond universe into three segments based on their convexity – essentially how sensitive the price of the convertible bond is to changes in the price of the underlying stock.
This means we segregate the market into low, mid and high delta (equity sensitivity) segments, and while a barbell approach between low and high delta holdings is often preferred by many managers, we have identified a growing number of opportunities in the mid-section.
Oil names are still unrepresented in the global convertible bond universe but the few higher delta names in this space have traded extremely well last year, and while there could be further upside given record profits from oil majors such as Shell and BP in recent weeks, any correction is likely to be more precipitous after a long, positive share price run.
We believe there is still value to be found in the lower delta segment of the market as several credit names in the convertible bond market are still trading at dislocated valuations compared to similar straight bonds. However, as many convertible bond issuers have no straight bonds outstanding, it remains a crucial task for fund managers to thoroughly assess the credit risk of the issuers.
In spite of these challenges, demand continues to outstrip supply when a deal is attractively priced.
A more recent example includes the issuance of two €500 million unsubordinated, unsecured convertible bonds2 from a German automotive and arms manufacturer, of which the proceeds of are helping to fund3 the acquisition of a close rival and competitor.
The outsized demand for the deal, which was significant for a European firm, came even as some funds steered clear of the bonds due to ESG restrictions.
It’s noteworthy that a fairly significant proportion of the above company’s bond buyers were hedge funds, an indication that the asset class possesses attractive value at present.
This confident issuance and the interest of hedge funds could prompt other European businesses to contemplate whether to issue their own convertible bonds; this is something that is frequently observed in US, with a flurry of issues often coming after a big name launches their convertible.
Furthermore, there are many relatively short-dated convertible bonds in the market already, and a large portion of these issuers will have to refinance their debt in the coming two years.
The make-up of the convertible bond market has long been dominated by US names, notably growth stocks in the IT and healthcare sector, but this has changed since the start of the pandemic. The asset class is now more diversified than ever with several relatively large companies in Europe and Asia tapping the convertible bond market.