CONVERTIBLE BONDS: ATTRACTIVE IN A LOW-YIELD ENVIRONMENT
Convertible bonds have risen in popularity with investors in recent years. Nathalia Barazal, Lombard Odier Investment Managers’ head of convertible bonds, explains more about these hybrid assets.
What is a convertible bond?
A convertible bond is a combination of a traditional corporate bond with a call option which allows either the holder or the issuer to convert the bond into a specified number of shares (equities) in the company in question at a later date. Convertible bonds are hybrid instruments that combine features of both asset classes. They feature some of the attractive characteristics of a bond: regular cash flow from coupon payments, the return of the principal invested on maturity, and a price that will only fall to the value of the bond floor. The investor can also benefit from some of the upside potential of equities, since the value of convertible bonds can rise as equity markets rise. This can be a significant benefit: if the company’s share price rises past a certain point, the investor can convert the bond into equity. If the share price falls, the investor can retain the bond.
As always with an investment, there is a trade-off between risk and return, and convertible bonds have some disadvantages. Because of the potential gains an investor could make on converting such bonds to equities, convertible bonds typically offer lower yields than regular corporate bonds. Companies issue fewer convertible bonds than regular bonds, so the market for them is smaller and less liquid. And since the issuing company also has the right to convert the bonds into stock, this can cap the upside an investor can make from a rally in the company’s share price.
How has the market evolved since the 2008 crisis?
Convertible bonds have become an increasingly popular asset class in recent years. A dip in issuance followed the crisis of late 2007, but a rebound was seen in 2013. Total convertible issuance for the first six months of 2015 hit USD 50.8 billion, according to UBS, on track to match levels seen in the previous two years. From an investor’s perspective, convertible bonds can be attractive in changeable or volatile markets, as they are typically less sensitive to changes in interest rates than traditional bonds. And while today’s low interest rate environment has weighed on both sovereign and corporate yields, and corporate bond yields have been depressed further by a high level of issuance in 2015 to date, that has meant a lower yield differential between traditional bonds and convertibles.
What have returns been like?
Returns have been similar to those for equities for the first six months of 2015, and have significantly outpaced those for traditional credit. As of 30 June 2015, the Thomson Reuters Global Convertible Composite Index (hedged in euros) has returned 3.8% year-to-date, above the 2.7% return of the MSCI World equity index, also hedged in euros. Convertible bonds have also outpaced returns for global high yield credit (the Barclays Global High Yield Index returned 3.1%) and global credit (the Barclays Global Credit index returned -0.1%).
Lombard Odier Investment Managers has a strong track record in convertible bonds, an experienced team and expertise built up over 20 years investing in the field.
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