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Why convertible bonds may be a preferred asset class in 2018
Market conditions, specifically high volatility in 2018, could likely favour convertible bonds over conventional stocks and bonds
Tom Wills 14 Dec 2017
Tom Wills is a portfolio manager at Morgan Stanley
Tom Wills is a portfolio manager at Morgan Stanley

A central theme throughout 2017 has been a widening of ‘extreme’ valuations. On one hand, assets deemed safe, like the stocks of S&P 500 companies, are at record high prices. On the other hand, assets with perceived high levels of risk, like the stocks of emerging markets, can be purchased cheaply.

For companies that fit the latter profile, convertible bonds (convertibles) have historically proved to be a useful tool to raise capital. Likewise for investors, they have historically performed well, when compared to conventional asset classes.

Convertibles allow bondholders to convert this security into equity at some point during the bond’s life. There are numerous reasons why a company will issue a convertible bond. A start-up, for instance, might be able to raise more capital by issuing debt rather than raising equity. A bond investor will in theory get their money back when the bond reaches maturity, and in addition own a proportion of a company — a powerful incentive for investors to part with their money.

Why now?
Historical data show that convertibles performed best relative to equities when volatility is not at depressed levels, as the optionality of convertible bonds benefits investors versus straight equity in higher volatility environments. But with today’s volatility at record levels, why would one invest in convertibles?

Today’s low volatility won’t last forever. Indeed, historical data is clearly showing that present-day volatility is so low that it is improbable for it to do anything but rise. And, let us not forget that there are many risks threatening the financial markets. Geopolitical risks such as North Korea, an unpredictable US government and Brexit could destabilise the equity markets should a major fall-out take place. In addition, an overzealous FED, ECB or BOE might also unsettle the markets, despite the unlikelihood of such action taking place. More likely, however, is that with valuations in safe assets continuing to rise, and corporate earnings increasingly failing to deliver inflated expectations to investors, volatility will likely recommence.

Furthermore, with a further three rate increases expected between now and end-2018 by the majority of the market, bond investors can expect more volatility as fixed coupon payments become less appealing.

Past to present
Using the data supplied by the Chicago Board Options Exchange Market Volatility Index — or Volatility Index (VIX) — and cross-checking this against performance data supplied by the S&P 500 Index and the Thomson Reuters Global Convertible Index, the following observations can be made.

First, in today’s low volatility regime, both stocks and convertibles could perform well, but as expected, stocks performed better due to implied strong equity markets and a drag from the cost of option insurance. However, when volatility reaches moderate levels convertibles outperform stocks. Indeed, once the VIX level reaches 17 — today it is at 13 — convertibles perform an average of 31 basis points better than stocks (see below chart).

The historical average for VIX of 19.5 sits in the middle of the 17-21 range as shown in the above table. This leads to the conclusion that convertibles will likely outperform equities during 2018, given the expectations on higher volatility, as outlined earlier.

Opportunities abound
Looking around the world, stable and improving investing conditions can be observed, that look as appealing as they did before the 2008 credit crisis. We are, therefore, reminded to maintain risk in portfolios, but at the same time, it is hard to see equities continuing to rise without more volatility. If volatility can only rise from here, then the prudent investor seeks to buy volatility when levels are low.

Convertibles could be one of the ways to own equity volatility, and lagging short-run risk-adjusted returns versus stocks suggest they could recover towards the long-run average.

 

Tom Wills is a portfolio manager at Morgan Stanley. Morgan Stanley says the views and opinions mentioned in this article are those of Tom Wills as of the date of publication and are for informational purposes only, not to be construed as investment recommendations.

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