Convertibles: still a ‘niche’ route to growth?

4 min read 24 Sep 20

Summary: At a mere 0.5%, in relative market cap terms, the global convertibles universe is dwarfed by its global equities counterpart.

Consider the ca. $440 billion market cap size of the global convertibles[1] universe in comparison to the some $90 trillion that makes up the global equities market. This ratio is also reflected in the indices used to compare both asset classes. For instance, the Refinitiv Global Focus Convertible Bond Index has ca. 200 constituents and a market cap of around $200 billion, while the MSCI AC World Index is comprised of ca. 2,984 constituents worth a combined $50 trillion or so in market value.

Traditionally viewed as a ‘niche’ asset class, convertibles are often overlooked by investors. Yet, they have been showing their mettle during the COVID crisis and, over the longer term, can boast near equity-like returns with less volatility.

A lower risk alternative to access high-growth opportunities

If investors are seeking young, high-growth firms but are concerned about elevated valuations, share price volatility and potential vulnerability to style rotation (into value or recovery stocks), then convertible bonds could offer an appealing alternative to equity investing.

The diversification benefits of the global convertibles market, together with the protective characteristics of the bond element, help to mitigate these risks. The ‘asymmetric’ return profile of convertibles (participating more in the equity upside than downside) can make them a valuable piece of the portfolio construction jigsaw.  

A complementary asset class

The starting point for any potential investors is to observe the significant differences in the composition of the equity and convertible universes. Investing in a diversified collection of global convertibles is not simply equivalent to gaining options on the largest equity indices such as the S&P500, Nikkei or FTSE All Share. Rather, convertibles provide optionality on a materially distinct subset of stocks.

…dominated by growth sectors

The global convertibles market has a very different sectoral breakdown from global equities, with the universe having higher exposure to technology, driven mainly by software, and a higher representation of consumer discretionary stocks (often online retail or e-commerce names) along with communication services names (mainly media and entertainment companies versus telecom operators). By contrast, there is much lower exposure to financials, particularly banks, and consumer staples firms. Although healthcare weightings are broadly similar, convertibles tend to be smaller, less diversified, early-stage players rather than large, diversified majors.

What is more, if we consider the degree of equity sensitivity, or delta, provided by each sector, rather than the absolute market value, the information technologyconsumer discretionary and communication services sectors become even more important to the future performance of the convertibles market.

What’s behind this sector divergence?

The divergence in sectoral breakdown arises from the type of companies that tend to issue convertibles. A large proportion of convertibles are issued by young, growing firms with innovative and developing business models. These are more prevalent in industries undergoing change at a rapid pace, such as technology, media, entertainment, gaming and healthcare, rather than the more traditional sectors like financials, energy, basic materials and utilities.

However, convertibles can also be issued by firms in those traditional sectors when they are distressed or in need of rescue financing. For instance, there was a flood of new convertibles issued by airlines, cruise operators and retailers who wanted to build cash reserves following the height of the COVID crisis in March. Similarly, many firms rebuilt their balance sheets with convertibles after the Global Financial Crisis of 2008-09.

Still, the typical financing needs of fledging firms in the rapidly-growing industries ensures that the convertibles universe maintains a consistent bias towards these sectors when compared with the wider global equities market.

From a style perspective, the companies issuing convertible bonds can generally be characterised as smaller, more volatile businesses that are highly-valued, offer rapid growth, and typically have higher momentum than the wider global equities market. In short, investing in convertibles means taking exposure to younger and faster-growing, if potentially riskier, enterprises.

Mitigating the risks of a ‘growth bias’ in the current environment

This may be particularly important in an environment where ‘growth’ investing has massively outperformed ‘value’ for an extended period of time (notwithstanding the recent market gyrations when growth stocks, especially the tech giants, gave up some of the turbocharged gains of August).

With many growth stocks now trading at elevated valuations, we are seeing much debate around a potential style rotation from growth to value, along with a shift away from COVID beneficiaries and structural or secular growth themes, towards more cyclical names or recovery stories.

This is where the unique ability of convertibles to limit downside share price potential could become highly valuable. Given the fundamental and market-driven rotation risks of investing in newer, rapidly-growing, more volatile firms, the convertible structure – offering the right to be repaid at maturity (providing a ‘bond floor’) – has the potential to mitigate these risks by limiting the downside while retaining the option to benefit from further upside growth. It may be an exciting ride, but the parachutes are also at the ready.

For investors, global convertibles can offer a distinctly different proposition to global equities; with the potential to deliver strong risk-adjusted returns while also offering a unique element of downside protection. With risks remaining in 2020, not least the imminent threat of a second pandemic wave and a highly-charged US election in November, we could continue to see further bouts of market volatility – an environment in which global convertibles could continue to shine.

[1] Convertibles are hybrid securities sharing the characteristics of fixed income and equity investments. They are issued as bonds, generally having a fixed coupon payment and redemption date, but have an important extra quality; the option to convert into shares. This equity link enables them to participate in equity market rallies, while their fixed income properties give them a ‘bond floor’ – the value that the bond would have if there were no convertibility attached to it – which can cushion them from share price falls.

By David Romani

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.

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