Four reasons why convertibles look well positioned in 2017

Convertible bonds could be one of the standout performers in the fixed income space in 2017, following the lacklustre year of 2016 in which they lagged segments of the market, says RWC Partners’ Davide Basile.
Basile, manager of the $1bn RWC Global Convertibles Fund, believes the sector is poised for a rebound this year following a tough 12 months which saw convertibles underperform areas including high yield.
“The asset class had strong years in 2014 and 2015 but its low duration and growth bias at the expense of sectors such as oil and financials meant it underperformed in 2016,” says Basile.
“However, severe yield compression, a prolonged economic cycle and a number of other factors mean the asset class is now in a sweet spot from a number of vantage points – fixed income, conservative equity or multi-asset.”
So why is now such a good time for convertibles? Below, Basile highlights the recent victory for Donald Trump in the US, coupled with a change in interest rate expectations and increasing demand for convertibles, as reasons why the asset class could be one for investors to focus on this year.
Yield compression
“Convertible bonds typically pay less income than other bonds because of the cost of the option to convert to equity.
“However, fixed income markets have changed a lot in recent years, with accommodative monetary policy driving yields sharply down. As such, investment grade corporates have seen yields fall further than those in the convertibles space; while convertibles have seen yields compress globally from around 2 to 2.5% to 1 to 1.5%, the corresponding move for investment grade debt has taken yields from 5% to between 1-2.5%.
“As such the carry or ‘opportunity cost’ of the convertible bonds relative to straight corporate debt is substantially reduced.”
Rising rate environment
“Since the start of the millennium, convertibles have outperformed during periods of rate rises; indeed, they have typically been the best performing asset class across the fixed income spectrum.
“Convertibles derive c. 60% of their returns from their inherent sensitivity to equity markets, so in a pro-growth environment we anticipate that rising equity markets will propel the asset class higher, and given the duration of the asset class is relatively low the impact of rising interest rates will be negligible, especially when compared to that of traditional corporate bonds.”
Volatility on the rise
“The change in the political landscape in the US, UK and elsewhere in the last year has been profound and has created a new wave of uncertainty. Trying to predict the outcome in financial markets even if you had known the outcome of such political events has proved difficult for asset allocators.
“For us as convertible bond fund managers, this increased volatility in markets is of twofold benefit. Firstly, from a valuation perspective, a pick-up in equity market volatility should feed through to an increase in the value of the equity option inherent in the convertible bond and hence help reduce any downside participation.
“Secondly, we notice that convertibles participate more with equities when volatility is higher and hence convertibles could provide investors with a more attractive way to get exposure to equity markets by allowing a strong participation to the upside while still retaining the usual capital preservation dynamics.”
Increasing issuance
“The final part of the jigsaw is issuance. Companies have been increasing their issuance of convertibles over the last few months in anticipation of rising interest rates, and selective participation in the new issuance calendar can enable managers to add alpha and further diversify their portfolios.
“In January 2017 alone CB issuance in the US exceeded that of the whole first quarter of 2016, and issuance this January on a global basis is twice that of this time last year.
“Basile says that over the longer term the asset class should benefit from its dynamic nature, with the bonds offering an attractive mix of downside protection and upside participation which enables returns to compound with low levels of volatility over time.”