Convertible bonds: Navigating opportunities beyond economic storm clouds

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This is a sponsored article from NN Investment Partners.

2018 was a difficult year for global financial markets with an unusually high percentage of markets across all asset classes posting negative returns. Global convertible bonds (CBs), by contrast, held up fairly well with only modestly negative returns. The equity sensitivity of the asset class decreased alongside global equity markets, and the fixed income component shielded investors from further declines.

Jasper van Ingen
Senior portfolio manager convertible bonds
NN Investment Partners

Against that background, Jasper van Ingen, senior portfolio manager convertible bonds at NN Investment Partners, says his team will remain focused on market fundamentals in 2019 and be wary of cognitive biases such as the recency effect — the tendency to make investment decisions disproportionately based on the most recent market events.

“The recency effect convinces investors that new information is more valuable and important than older information,” he explains. “This may be true, but it is not necessarily the case. Investors tend to base their market expectations on how the market has been performing recently, whether good or bad.”

“In times like this, it is easy to overreact. In 2019, we intend to focus on the long term, and to continue using the merits of the convertible bond asset class as best as we can. This has served us well in the past, and we are convinced it will give us the highest probability of success in the future.”

Gloomy headlines obscure economic realities
Despite relentlessly negative headlines about tariffs and trade wars, the reality is the world is currently seeing healthy, albeit slower, economic growth and upward pressure on interest rates due to the phasing out of monetary stimulus. This environment may present a buying opportunity for CBs. The equity-like characteristics of CBs mean they benefit from economic growth but are only modestly impacted by rising rates because of their low effective duration, which averages 1.8 years across the asset class.

Rising yields present a strong incentive for corporations to issue CBs that typically pay lower coupons, resulting in a significant increase in the volume of new issues of CBs. The phenomenon can be largely attributed to rising interest rates in the US, as a large part of the new USD CBs have been brought to the market to refinance high yield and investment grade bonds.

Global issuance is likely to remain strong going forward, driven not only by the US but also by Europe where a similar trend is likely to emerge following the end of the ECB bond-buying programme.

A unique positioning between equities and bonds

Convertible bonds performance versus major asset classes
CBs have historically provided equity-like returns with lower volatility and downside protection.

Note: 1997-2018, 1997=100, USD. Unhedged data until December 2001, USD hedged thereafter.
Source: Bloomberg, Thomson Reuters, ICE BofAML, Data as of December 2018

 

Analysis1 shows the CB asset class has outperformed equities over the last 20 years with 26% lower volatility, highlighting the potential added value of CBs to investor portfolios. CBs can also be a powerful diversifier within portfolios, due to their high correlation to equities but limited correlation to high yield bonds and even negative correlation with government bonds. The analysis shows CBs have displayed an 84% correlation with equities over the last 20 years but lower correlations of 72% and 41% with high yield and investment grade bonds, respectively. They showed a negative correlation of -11% with government bonds.

“The outperformance of fixed income by equities and CBs in a rising rate environment is a fairly consistent pattern dating back to the 1980s. In times of rising rates, equities have historically performed well as interest rates have risen to counter economic overheating, thereby boosting CB returns,” van Ingen explains.

“At the same time, CBs are less affected by rising rates than non-convertible bonds due to their lower duration. Rising rates also provide a strong incentive for companies to issue CBs as the coupon rebate that issuers receive becomes more material. This also gives more choice to investors. In this context, the strong positive momentum in global CB issuance in 2018, which is the highest since 2007, is no surprise.”

Identifying opportunity with a theme-based approach
At NN Investment Partners, the convertible bond investment team uses a theme-based framework to identify attractive medium-term investment opportunities. At present, van Ingen sees several key themes offering strong potential in the CB market, including electronic components, healthcare spending, and cloud computing. He believes these themes will benefit from rising demand for electronic devices with ever more components to increase their functionality, a growing population that is capable of affording healthcare-related services, as well as an increasing need for cloud data storage.

The team is typically positioned conservatively when it comes to credit exposure.

“We are closely following a number of events and possible risks in the coming months, including a potential further escalation of the trade war, Brexit, and a possible resurgence of geopolitical tensions,” says van Ingen. “It is important to construct a portfolio that can weather market disruptions by selecting CBs with strong credit fundamentals.”

A partner with strategic intelligence
At NN Investment Partners we manage investment strategies well-suited to capturing the essence of the opportunities offered by the CB market. Our strategies offer a higher relative risk-adjusted expected return, equity participation with contained expected volatility, and downside protection. The strategies are global, supported by in-depth credit research, and concentrated on a select number of CBs that combine solid credit fundamentals, underlying equity upside, and a balanced convertible profile with attractive valuations. Our strategies are managed by a dedicated and experienced team of highly rated CB experts.

For more information, click here or contact NN IP: meilin.tan@nnip.com

1 Source: Bloomberg, NN IP analysis 20 years to 31 December 2018, Thomson Reuters Global Convertible Bond Index, MSCI World, BoAML Global Broad Market Corporate Index, BoAML Global Government Bonds Index, all in USD, hedged after 10/2002.

Disclaimer
This document is for informational purposes only and is not the basis for any contract to deal in any security or instrument, or for NN Investment Partners (Singapore) Ltd (“NNIP SG”) or its affiliates to enter into or arrange any type of transaction as a consequence of any information contained here. It shall not be construed as or used for the making of any offer or invitation to anyone in any jurisdiction in which such offer is not authorized, or in which the person making such offer is not qualified to do so, or to anyone to whom it is unlawful to make such an offer. Although the information in this document was compiled from sources believed to be reliable, no liability for any error or omission is accepted by NNIP SG or its affiliates or any of their directors or employees. The information and opinion contained here may also change.

Use of the information contained in this communication is solely at your risk. Investment sustains risk. Please note that the value of your investment may rise or fall and also that past performance is not indicative of future results and shall in no event be deemed as such.
Any claims arising out of or in connection with the terms and conditions of this disclaimer are governed by Singapore law.

NN Investment Partners (Singapore) Ltd | Company registration number: 199602506R

This is a sponsored article from NN Investment Partners.

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