As corporate bond investors face up to the inevitability of rate rises they have been piling in to convertible bonds with a view to combining the downside protection of fixed income with the potential upside of rising equities.
"There is no doubt that we are at the beginning of a cycle of rising rates, and we have made sure that we are in a good position to insulate ourselves as much as possible," says Brian Kennedy, a portfolio manager and investment strategist at Loomis, Sayles & Company in Boston. "It’s about finding asset classes that won’t correlate with rising rates, and we have had some success adding convertibles, because the price of the underlying equity goes up as rates rise."
Despite generally improving credit quality, the recent jump in rates has undermined returns on corporate bonds, and the 52-week return on US corporate bonds is minus 1.18%, despite tightening spreads, according to Bloomberg data. The Dow Jones Industrial average, meanwhile, has returned 16.1%.
The primary attraction of convertibles in this market is the potential upside on conversion into shares on maturity.
Investors on average are able to convert into equity when the share price is at a 25% to 35% premium to its level at the time of issue. With the S&P500 touching an all-time high in May, confidence has risen that the balance between a lower coupon and potentially obtaining shares at a discount has swung in their favour.
Inflows into convertible bond funds were $7.42 billion in the year to September 23, according to data provider EPFR Global. That compares with outflows of $1.28 billion to date last year.
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Although convertibles are a seemingly simple antidote to rises in the cost of borrowing, they are not straightforward instruments to value. That is because of the embedded optionality in the security, priced according to the implied volatility of the underlying. The optionality in convertibles has proved to be attractive to hedge funds, which look to trade volatility by buying the convertible and taking an offsetting short position in the underlying stock. The effect is to cut exposure to directional trends in the share price.
However, hedge fund participation in the convertibles market is a mixed blessing for real-money investors because the price discovery they provide is offset by short positions on the stock, which undermine those who want to see the share price rise.
In any event, according to some market observers, the impact of hedge funds has declined recently, with around two-thirds of primary-market placements now going to long-only players.
"The arbitrage trade was common in the convertibles market in previous years, but their influence is less than it used to be," says Frank Heitmann, European head of EMEA convertible origination at Credit Suisse. "We have seen more money flowing into long-only funds, which is balancing the influence of the hedge fund participants, alongside lower levels of leverage and convertible valuations which are less attractive from a volatility point of view."
Still, that point of view might not take into account the difference in perspective between long-only and hedge fund investors.
"The impact of technical factors and investor composition on valuations across the CB universe is unmistakable," says David Puritz, a New York-based portfolio manager at Blue Mountain Capital, which set up a dedicated convertibles fund last year. "Outright investors historically focus on balanced convertibles for convexity purposes, meaning they tend to prefer profiles with a significant degree of equity participation. Conversely, in-the-money, low-premium paper is less desirable from an outright perspective, given those bonds trade mostly lockstep with equity prices and are a significant distance away from their investment value floors.
"In an environment defined by limited supply, decreased hedge participation and a reduced sell-side appetite for inventory, it is not surprising that the in-the-money segment of the market trades ‘cheap’ to richer balanced names."
He adds: "From a hedge valuation perspective, large portions of the low-premium universe trade as cheap as they have in some time. Hedge accounts can source synthetic equity puts at low or zero implied volatilities, sometimes carrying these puts at a net credit, meaning at net positive cashflow when setting the convertible up against common stock. Convertible hedge investors can either pay very little or even in some cases get paid to own a put, running very manageable risk while also getting long corporate action options, such as incentivized early conversion, to boot."
As investor demand for convertibles has risen, issuers have responded. Globally there has been $62.8 billion of issuance year-to-date, compared with $41.7 billion in the same period last year, according to data provider Dealogic.
"We have seen a good pick-up in issuance responding to strong demand," says Heitmann. "Since the summer, ticket sizes have come down a bit to €100 million to €300 million from over €500 million, which is probably due to companies not having the same funding needs as previously, but demand has led to a rise in valuations." On an implied-volatility basis many convertibles are trading at a premium to historical and over-the-counter volatility, Heitmann says.
The year-to-date total return of the Barclays Europe, the Middle East and Africa (EMEA) convertibles index is 6.3%, compared with 12.9% in the same period last year, and 16.4% for the whole of 2012. On a 12-month view, European convertibles are likely to gain 9.7% if equities rise 25%, according to Barclays analysts.
Companies to have recently taken advantage of investor demand include unrated French retailer Rallye, global steel producer Aperam and US online travel company Priceline.com, which raised nearly $1 billion from a seven-year convertible at the end of May.
Mandatory convertibles, usually reserved for companies looking to raise large amounts of equity capital (for example for an M&A transaction) have accounted for about 20% of issuance this year, bankers say, against 50% for vanilla convertibles and 30% for exchangeables.
The European mandatory market was reopened after a three-year break last November, when Volkswagen launched a €2.5 billion deal. One of the reasons for the Volkswagen deal’s success, says Credit Suisse’s Heitmann, was its heavy marketing in the US, where a lower proportion of hedge fund investors meant there was less downward pressure on the shares.
As long as equities and swap rates continue to rise, investors are likely to continue their love affair with convertibles, analysts say. Of course, on the flip side, if rates rise too much, the market might begin to suffer.
"Right now it makes a lot of sense for investors to look to soften the impact of rising rates by taking more equity risk," says Blue Mountain’s Puritz. "Of course they should also remember that if rates rise too much, the effect on the equity market can be negative."