During the past five years, financial markets have had regular reminders – in the form of ‘taper tantrums’ across risk assets – of the perils of possible quantitative easing (QE) wind-downs. However, after such short-lived bouts of volatility, equities and bonds have remained largely complacent in 2017, despite expectations of further interest-rate increases in the US and the possibility that the ECB will reduce its QE in 2018 as European growth accelerates.
With recent moves in the spreads of high-yield bonds over government issues indicating increased investor resistance to ultra-low coupon-paying debt, and an ambitious tax reform plan in the US that could boost the prospects for equities, this could be the right moment to revisit the case for global convertible bonds.
The quest for better Sharpe ratios
In 2017, as of the end of October, balanced global convertible bonds were on track to outperform global HY bonds by more than 500bp, a margin last seen in 2013, the year of the first ‘taper tantrum’. Simultaneously, equity market volatility, as measured by the VIX index, has remained subdued, falling to an all-time low of 9.
With market volatility inversely correlated to central bank QE-related bond purchases since 2009, we believe a sustained rise in volatility and an increase in equity correlation is due. And because convertible bonds tend to outperform both spread products and equities on a risk-adjusted basis during periods of rising volatility, adding exposure to convertible bonds can be beneficial in the quest for higher Sharpe ratios.
Exhibit 1: Global index, total return
And what about duration risk?
With sensitivity to the underlying equities currently being the main performance driver for convertible bonds due to more balanced deltas in the investment universe, and with tenors in the three to five-year range, our view is that impact from any rises in interest rates should be limited – provided that equity markets, after the initial correction that the resulting rise in bond yields would cause, continue to integrate the positive outlook for global company earnings.
A regime change for volatility could be favourable too for convertible bonds
Although valuations – in some regions a significant portion of the convertible bond universe – currently appear rich in terms of their implied-to-realised volatility ratio, our scenario of a regime change in volatility should be lead to a rise in valuations for the asset class. This would result from financial markets and investment models marking up an upswing in future expected volatility.
Plain vanilla convertible bonds offer singular exposure to long-dated volatility and can be a valuable play on cyclical sectors.
MiFID II should bring greater transparency
European convertible bonds, as part of the over-the-counter and fixed-income investment universe, look set to benefit from much greater transparency via the new rules being adopted in January 2018. After significant flows over the last two years – substantial outflows in 2016 followed by a stabilisation in 2017 – we believe pricing dissemination and data availability will deliver a healthier environment in terms of liquidity, similar to that currently available in the US via TRACE (Trade Reporting and Compliance Engine).
Finally, what about the ‘Trump Bump’?
Lest we forget, this year’s equity market performance may have been influenced by the US presidential election results. But we expect convertible bonds to benefit even further in structural terms from one of the current proposals in the Republican party’s tax bill: limiting corporate interest-rate deductibility.
This significant change could potentially alter the after-tax cost of interest for companies and deliver a surge in convertible bond issuance, typically priced at lower coupons. While the legislative outcome remains in flux, we foresee further added benefits from the hotly debated repatriation tax. This would impact information technology – the largest sector in the convertible bond universe – by likely triggering a wave of share buybacks, higher dividends and stepped-up merger & acquisition activity.
Written on 24/11/2017