Analysis
By Arnaud Brillois, Head of Convertible Bonds Management at Lazard
Benefiting from both the rise in equity markets and the low volatility of bonds, convertible bonds offer a particularly attractive investment profile1. In 2020, they demonstrated just how attractive they could be in the midst of the Covid-19 health crisis.
There are many events that can spur uncertainty and significant movements in the equity markets, anything from financial crises or political surprises to the current health crisis. For savers, these ups and downs are often a source of concern. On the other hand, bond markets are much less volatile but are sometimes considered to have too low of a payout given the current low interest rate context. Few investors are familiar with convertible bonds, which are nevertheless the halfway point between these two solutions and can meet their expectations.
An enticing risk/return ratio
The figures speak for themselves. In the long term, convertible bonds achieve a performance close to that of equities, while maintaining volatility that is reduced by a third or even half compared to this asset class. Over the last 10 years, from 28 February 2011 to 28 February 2021, the Thomson Reuters Global Convertible Bond index has thus increased by 8.2% on an annual average with a volatility of 10.2%, while the MSCI All Country World index (equity markets) grew by 8.8% on an annual average with a volatility of 14.1%. The explanation behind this phenomenon is simple: a convertible bond behaves both like a stock and like a bond.
A convertible bond is issued by a company that wants to finance itself in the form of debt, while leaving the possibility of this debt being repaid in stock if investors so wish. When the company’s stock goes up, it pulls the value of the associated convertible bonds up along with it. On the other hand, if the share price falls, the convertible bond’s parachute effect is triggered: if the conversion into shares is no longer attractive, then the debt will ultimately be repaid in cash in its initial amount. This limits its potential downside[1].
So, a convertible bond therefore behaves more and more like a stock as the stock market goes up, and more and more like a bond when the market goes down. It also offers a regular coupon and redemption at maturity1. This mechanism proved its worth in February-March 2020 by allowing convertible bonds to significantly cushion the drop in equities, while benefiting from the subsequent rebound.
Essential active management
Of course, these assets are not without risk, the main one being that of default by the issuing company, which can cause the investor to lose all or part of the capital. Fortunately, this risk remains low: over the past 20 years, the default rate for convertible bonds has even been 45% lower than for traditional bonds, according to data from S&P and Bank of America. However, risky situations must be identified and avoided.
Another risk associated with bond markets is interest rate risk. Categorically, when market rates rise, the value of bonds already issued falls. However, convertible bonds have the advantage of not being structurally susceptible to this risk. In addition, phases of rate hikes historically correspond to phases of a simultaneous rise in equities. As such, the positive and negative effects balance out for convertible bonds, unlike what is observed for “classic” bonds.
Active management is ultimately essential not only to manage events related to these securities (redemptions, choice of conversion), but also to identify the most promising companies, geographic areas and sectors. The world of convertible bonds is truly characterised by its great diversity. It is up to the manager to choose the right issuers, whether they are high growth companies, large caps or companies that are ready to recover after the crisis.
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The opinion expressed above is dated March 16th, 2021, and liable to change.
Source : Bloomberg
Main risks associated with investing in the convertible bond market: risk of loss of capital, equity risk, interest rate risk, credit risk, currency risk, volatility risk, derivative instrument risk, counterparty risk, risk associated with emerging countries.
The information provided is not intended to constitute investment advice and is intended for information purposes only. The data used in this document is used in good faith, but no guarantee can be given as to its accuracy. All data contained in this document, unless otherwise indicated, comes from Lazard. Past performance is not a reliable indicator of future performance.
This document is the intellectual property of Lazard Frères Gestion SAS. LAZARD FRERES GESTION – a simplified joint stock company with share capital of €14,487,500 – Paris Trade and Companies Registry No. 352 213 599. 25, RUE DE COURCELLES – 75008 PARIS, FRANCE
[1] Except in the case of default by the issuer; see the paragraph entitled “Essential active management”.
