Convertible bonds (CBs) are hybrid instruments which combine a traditional corporate bond with a call option on the underlying equity, meaning if the stock reaches a certain price the holder can convert the bond to equity. The optionality in convertible bonds allows investors to participate in the upside potential in equity prices while receiving the downside protection of holding a bond when equity prices move down.
Before 2008, hedge funds and proprietary trading desks were the main players in the CB market, representing 80% of volumes. They have now been replaced by institutional investors who regard the instruments as a long term investment. For instance, CB are attractive for investors who are subject to Solvency 2 regulations, as the cost of capital of an investment in convertible bonds is lower than that of an investment in equities.
Mutual funds, pension funds or insurance companies are now the main players on the market. Mutual funds dedicated to CB own approximately 15% of the EUR400bn global convertible bond market. Convertible bond fund assets under management have stabilised above pre-Lehman levels at EUR55bn.
The “institutionalisation” of the CB investor base means that the CB market is subject to less arbitrage, less trading and less leverage. This has had a positive effect on the stability of the asset base but a negative impact on the liquidity of certain segments of the market such as small caps and high yield. Furthermore, as institutions are typically buy-and-hold and long-term investors, it can become tricky to find sellers for some widely invested CBs from large cap investment grade issuers. Yet, the consequence of a drop in liquidity, as was observed in July 2011, was far less severe than in 2008 in the absence of excessive leverage and forced selling.
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As arbitrageurs are less active, more mispricing opportunities appear on certain bonds. This has led to an increasingly dual market, split between liquid, rated, large CBs and CBs from smaller cap issuers that are less liquid, more volatile and characterised by more valuation disparities.
The low level of issuance over the past few months is resulting in a reduction of the investment universe, particularly in the balanced segment and in Europe. A shrinking European market and risk aversion has resulted in global CB funds attracting inflows and European CB funds suffering from outflows as of June 2012.
CB Funds Population
Global funds represent around half of the total universe (compared with approximately 40% in 2007). Global funds experienced strong inflows in 1H12 (USD1.8bn), while European funds showed outflows of USD860m.
The CB fund market is fragmented with 86% of funds having less than EUR250m of assets. Five funds have Asset Under Management (AUM) of EUR1.5bn or more. However, almost 40% of CB Fund Assets are held by the top 10 Managers. There are few major players in the CB fund management industry as only five asset management companies have a total convertible bond fund AUM in excess of EUR2bn.
Performance drivers vary depending on a fund’s profile (“bond-like”, “mixed” or “equity-like”), underlying credit quality (investment grade or high yield), capitalisation breakdown (large or mid/small cap) and currency exposure (hedged/unhedged).
Global convertible funds have returned an annualised 9.5% over the past three years, approximately the same return as global equity but with 50% of the volatility based on Lipper data.
However, over the past three years, CB funds have captured more of the market downside and less of the market upside than expected, according to Fitch’s research, which may point to greater credit sensitivity, notably in high yield. The CB fund market is increasingly fixed income by nature. Credit, particularly EMEA high yield, has been a fund performance driver in 2012.
– Yield, convexity (ability to generate asymmetric returns) and overall risk profile. Yield and convexity are two characteristics of CB that make them attractive in the current market and that asset managers focus on in their bottom up analysis. Yield analysis relative to credit quality requires strong credit skills, notably as high yield, unrated and small caps names are growing in importance in the CB universe. Maintaining convexity also requires discipline in portfolio selection.
– Management of market sensitivities While bottom-up analysis is the essence of CB investing, certain funds could gain from a more tactical, dynamic management of delta with a short-term investment horizon.
– Management of supply constraints and liquidity; A reduction in the amount of CBs available for investment, currently around EUR400bn globally, resulting from lower issuance is becoming a concern, particularly in Europe. Capacity and concentration are two risks that investors need to be aware of in this context. Furthermore, investors need to be prepared for abrupt drops in liquidity given imbalances in supply and demand and thinner liquidity on high yield and small cap issues.
– The ability of CB portfolio managers to draw effectively on wider shared resources. CB investment is a niche strategy, which requires specialist skills. CB investment teams tend to be small, consisting of three to ten dedicated investment professionals. However, the inputs to the process a multiple. So, the ability to effectively use global credit, equity and macro-economic research resources, can be a differentiating factor among investment processes.