In the first of a two-part look at convertible bonds, leading fixed income managers indicate what major challenges the sector faces over the near-term and where asset allocators can look for outperformance.
Fund managers are broadly optimistic about the prospects for global convertible bonds over the next couple of years – as long as the economic backdrop remains relatively benign and companies enjoy a further uptick in fortunes.
Miles Geldard, co-manager of the Jupiter Global Convertibles Sicav fund, believes modest economic growth is likely to continue around the world and such an environment will be supportive for the asset class.
‘Historically, as long as there has been some growth in earnings to support equity prices, increases in the equity element of convertibles have more than offset declines in the bond element driven by bond yields rising,’ he says.
At present he has a preference for the value identified in Asian/Japanese convertibles and believes that sentiment towards China has become too negative even though there are ‘skeletons in the credit closet’ and projected GDP growth rates are likely to decline further.
‘We therefore hold a range of convertibles in Asia ex-Japan, while avoiding Chinese property companies,’ he says. ‘While convertible deltas in Asia ex-Japan are generally lower than US and Japan, they have increased in the past month and will thus tend to have a more significant participation rate if there are further gains in equities.’
The number of large, high quality convertibles in Asia trading near their bond floors is also attractive. ‘We continue to have significant exposure in Japan given its increasingly shareholder-friendly environment and the fact that the equity market there has risen on the back of substantial earnings increase rather than simply growing optimism,’ he says.
However, he does point out that convertibles are a microcosm of the financial market, which means they do reveal pockets of speculation. As such it is no surprise that lots of issuance has been seen in areas such as US biotechnology and the internet, and European property.
It’s a temptation he has managed to resist. ‘We have avoided these as, in our view, the underlying equities have excessively high valuations while the bonds are sometimes of a lower credit quality than we would like,’ he says.
Mike Reed, manager of the BlueBay Global Convertible Bond fund, is also optimistic about the future, as he believes the outlook for the main performance drivers of the asset class remain very constructive.
‘Convertibles are ideally suited to an environment where credit spreads are tightening and equity prices are rising,’ he says.
‘Our view on global equity markets remains positive and our positioning reflects this.’
He points out that improving economic growth prospects filter through to company profits, and then to equity prices, which are in turn being underpinned by enhanced dividends, increased share buybacks and M&A activity.
‘We do not believe that a rise in defaults is likely in the current climate,’ he says. ‘The last period of major corporate leverage build-up ended with the financial crisis, companies are now cash rich and balance sheets are cleaner.’
The actual risk of default remains lower than the long-term average, he suggests, pointing out that companies are readily able to finance/refinance, and the servicing of coupon payments is less onerous than at other points in the cycle.
A theme he has favoured for some time is the value inherent in many emerging markets. ‘For investors wishing to access the growth of EM companies with lower volatility than a direct investment in the local equity markets, convertibles can be the ideal asset class,’ he says.
‘Our main regional focus in the EM is Asia and specifically the countries and companies most likely to benefit from Chinese growth. With China projected to grow at 7+% in 2014, our overweight exposure to the region has been our strongest performance generator over the past 12 months and we forecast that this will continue in 2015.'
‘In our view, convertible bonds are the ideal asset class for investors wishing to participate in the performance of the equity markets, but with lower volatility, and the fixed coupon/finite maturity features of the fixed income market.’
Good earnings growth
Jacques Berghmans and Hubert d’Ansembourg, the managers of the Treetop Convertible International Sicav, believe that good quality earnings growth is scarce and argue that it is more difficult to find companies fitting their criteria.
This is because the main qualities they look for are businesses that are leaders in a growing sector, with a high margin versus their peers, and a high return on equity. The strategy appears to be paying off as the duo are ranked second and first over three and five years respectively.
‘If there is no convertible available for this stock, we construct a synthetic convertible by separating fixed income and a two or three-year warrant on the stock,’ says d’Ansembourg.
Looking ahead, the managers remain quite positive on the outlook for equities because they don’t believe the markets are expensive versus the level of interest rates, which are expected to stay low for a while.
‘The risk premium of equities is, therefore, quite comfortable,’ says d’Ansembourg. ‘A lot of institutional and household savings are invested in low interest accounts and have not yet rejoined the stock markets. However, good quality earnings growth is scarce and it’s important to be very selective in order to outperform.’
Geographically, they think the underperformance of emerging markets is coming to an end and have begun to increase this part of their allocation.
Meanwhile, on a general construction level, the portfolio is currently positioned towards durable growth.
‘We don’t see any particular reason to buy convertibles now but we always view them as a safer way to play the long term growth of stocks and a good way to avoid individual big mistakes that may cost a portfolio a lot,’ he adds.