The recent reversal of implied valuations of Global and European convertible bonds offers a good entry point to the asset class. Implied volatilities are below their historical average and we anticipate richening. Global implied volatilities, in particular, are currently slightly above European ones, standing at 30.5% against 29.8%, but we still expect the global universe to outperform Europe and reach levels well above historical averages.
IMPLIED VOLATILITY: AN ESSENTIAL VARIABLE FOR THE MANAGEMENT OF CONVERTIBLE BONDS
- One of the most noticeable characteristics of convertible bonds is their « convexity ». This allows investors to benefit partially from increasing equity markets, while hedging against declining ones. To avoid overpaying this specific advantage, investors can focus on the implied volatility of options.
- Investors can analyze the implied volatilities of all convertible bonds to estimate the implied volatility by geographical zone. This measure then helps them to assess whether the zone is expensive or not by comparing current implied volatility to the historical average.
- In our issue released in July 2016, we discussed the sustainability of implied volatility levels as we deemed them undervalued globally and, particularly, in Europe.
- Recall that, at the time, we mentioned « Valuations of convertible bonds are at attractive levels in all geographical zones, as reflected in the historically low level of implied volatility: nearly 20 % lower than historical averages ». The difference was particularly noticeable in Europe.
- We believed it was wrong to link the differences in valuations to an actual decrease in volatility, as it seemed more like a continuation of the upside trend started in early 2015, and reinforced in 2016.
- In our view, the low level of implied volatility was linked to a temporary risk aversion. The significant volume of convertible bond new issuance in Europe since the start of the year had also weighed on the valuations by diminishing the scarcity effect.
VALUATIONS HAVE CHEAPENED AND ARE NOW ATTRACTIVE
- In February, global implied valuations reached 34.6%, a 3 years high, driven by the US convertible bonds market and the technology sector in particular.
- Since then, global valuations cheapened 4.1pts and came back under their historical averages. This has been caused by the low volatility of the market in general, that started to feed into long term implied volatilities. We anticipate that they will rapidly start to richen again, driven by inflows in the asset class and redemptions of called CBs.
- In Europe, implied valuations cheapened 4.9pts, and are currently standing 2.7pts below their historical average, the area should richen as well, due to the scarcity effect after a particularly weak primary market this year.
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