Published August 2017

Convertible bonds as an asset class

  • Convertible bonds (‘CBs’) are fixed income instruments that can be converted into shares
  • Firstly, they offer the benefits of a debt instrument as they pay fixed coupons and are redeemable at maturity at a pre-specified price
  • Secondly, the embedded conversion option provides an investor with the ability to participate in the upside potential of the underlying equity

  • CBs’ prices change in relation to stock price movements

  • We believe the best risk-return profile can be found in the mid-price segment – the balanced area
  • As the characteristics of the market change over time, active management is key

 

Why invest in convertible bonds?

  • CBs offer equity-like returns with reduced volatility – an asymmetric return profile results in upside potential to equity markets with downside limitation
  • CBs can provide a better return per unit of risk than most traditional asset classes – they typically have an improved Sharpe ratio
  • They offer a compelling opportunity for a defensive investment in global equity markets

Why the time is right for convertibles

There is the potential for further rates volatility in 2017. CBs are well suited to this type of environment as they exhibit lower interest rate sensitivity than conventional bonds due to their embedded optionality. The asset class has historically performed well in periods of rate rises.

 

Furthermore, a trend towards normalisation in rates plus the reversal of the pattern of money chasing central bank liquidity has led to signs of the start of a ‘great rotation’. As investors migrate away from fixed income and into equities, CBs represent an ideal intermediate stop. For fixed income investors looking for lower duration with equity upside they make a lot of sense and the defensive benefits of the product are also attractive for equity investors, who feel the risks facing markets are not fully priced in.

 

In addition M&A activity is expected to be elevated in 2017 which is very positive for CBs. Not only does this provide a tailwind to primary supply, as discussed below, but CBs also offer excellent upside optionality compared to straight bonds in an M&A scenario.

 

We have also recently witnessed the emergence of an unprecedented bifurcation between the larger ‘index eligible’ portion of the CB universe and the smaller, more off the run segment, which is creating significant value opportunities for us to target.

 

Finally, we are very optimistic on the outlook for the primary CB market in 2017, with a number of expected supply-side benefits which are discussed in more detail below.

 

In short as investors face up to multiple macroeconomic headwinds and political uncertainty and as we shift from a world of monetary to fiscal policy, it makes sense to own optionality and convexity, both of which are embedded into CBs.

 

CB issuance is expected to rise in 2017

2017 has started strongly with healthy issuance levels.

 

The US currently represents 60% of the outstanding CB market and primary supply is expected to pick up in 2017 on the back of a number of drivers discussed in more detail below.

 

Rates: The recent era of ultra-low rates has been a headwind to CB issuance. The low cost of borrowing allowed lower credit quality or first time issuers to issue straight debt instead; a market they could not previously access. If Fed policy and Trump’s proposed fiscal expansion does cause yields to normalise, these types of issuers are likely to return to the CB market with its lower all in coupons.

 

As can be seen below (chart 1), US CB issuance has been historically correlated to rates.

Chart 1. US CB issuance and US Treasury 5y rates correlation 2002-2016

 

M&A: M&A activity has historically been a core use of proceeds from new CB issues. The expected repatriation of funds coupled with the revival of ‘animal spirits’ may lead more companies to consolidate through M&A and in doing so provide a material tailwind to CB issuance.

 

“Companies seeking growth will likely turn to mergers and acquisitions to boost their prospects in 2017, leading to surging deal flow, according to a new report from Ernst & Young LLP.”
Wall Street Journal, December 2016

 

Equity markets: Momentum seen in equity markets has broadly carried through into 2017. Companies typically prefer to issue CBs when their underlying equity has performed well as it lowers the potential dilution. A continuation of equity performance should therefore be supportive to CB issuance.

 

Other catalysts: There are a number of other possible catalysts due to the policy shifts expected in 2017 with reflation and a broader expansionary business environment both positive for equities. Other enduring benefits issuers can gain through using CBs, such as their flexibility in terms of structure and their potential speed to market, also add to the case for companies to access the CB market in 2017.

 

Tax reforms a potential further boost to US inssuance

One further possible tailwind to CB issuance levels could come through US tax reform plans proposed by Trump’s administration. These include slashing corporate tax rates while a proposed offset to this is removing the tax-deductibility of interest payments on corporate bonds.

 

This may increase the attractiveness of issuing CBs which, due to the value of the equity conversion option, traditionally pay a lower coupon than their straight bond equivalents. Issuers looking to bring down their costs of capital may therefore turn to the CB market where in addition, relative to issuing equity, any dilution is reduced.

 

This approach seems logical for corporate treasurers looking to monetise strong equity performance in a tax effective way and could provide a boost to CB issuance from the US in 2017 and beyond.

 

Why is the primary CB market important?

While primary CB volume is important, it is certainly not as simple as issuance ‘at any cost’. More issuance is not always positive.

 

On the one hand CBs are not ‘permanent capital’ (being either repaid or converted into equity) so a certain amount of new issuance being injected into the market is necessary for its overall health.

 

On the other hand however, the profile of this issuance is important as is the net supply impact on the market.

 

The demand is seemingly there from investors to digest increased supply. Barclays’ view is that substantial pent-up demand in the asset class could ‘easily absorb some USD47-52bn in 2017’ by their estimate1, driven among other things by upcoming maturities and coupon income. To put the numbers in context, total CB issuance from the US in 2015 and 2016 respectively was USD37bn.

 

In terms of the profile of new issuance we are much more optimistic than in recent periods about the pipeline, given our conversations with a number of structuring banks.

 

The US, as discussed above, has been the clear driver of supply in recent years however we see reasons for optimism in other regions. In Europe a number of deals of late have come at quite unattractive terms. As the macro backdrop evolves we hope to see more pushback from investors leading to less aggressively priced, more balanced transactions.

 

While there has been a distinct lack of recent supply from Asia overall, we look forward to an uptick in primary supply from Japan where the equity recovery and increased amounts of corporate activity in the region could lead to a renaissance in CB issuance.

 

On a less formal basis, new issue levels have always been closely watched in the CB market and have historically drawn investor attention to the asset class. The entry or re-entry to the market of household names in recent years has shone welcome light and coverage on what is (wrongly in our view) a perennially overlooked and under-researched asset class.

 

Finally, the primary market is also an important source of returns for active CB strategies, with a positive correlation existing between performance of the asset class and issuance levels in the US CB market in recent years.

Chart 2. US CB returns are correlated with issuance levels 2008-2016

 

GLG Global Convertibles Strategy

Fundamental, bottom up equity and credit research focus

  • Truly global approach with specific portfolio managers and analysts covering each region
  • Ability to leverage the wider GLG credit and equity hedge fund platform creates a unique long only performance edge

 

Convertibles are complex and require experienced and well-resourced portfolio management

  • GLG has a strong, established and seasoned team of convertible bond specialists, headed by Danilo Rippa
  • The team:
    • Have significant convertible structuring and origination experience at leading investment banks
    • Bring a deep understanding of crucial primary market, takeover and restructuring dynamics

 

The Strategy has maintained reasonable capacity levels relative to far larger Funds within its peer group

  • Enables flexibility and potential for meaningful outperformance

 

Multi-layered risk management process with an embedded risk manager and independent risk oversight

  • Daily liquidity and transparency driven by UCITS compliance

 

Strong long-term track record

The Strategy has shown strong relative, absolute and risk adjusted performance against other asset classes.

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