This is a sponsored article from NN Investment Partners.

Written by Ivan Nikolov, Senior Portfolio Manager and Tarek Saber, Head of Convertible Strategies

Convertible bonds (CBs) are, possibly, ideally positioned in today’s market environment as an excellent investment proposition. Economic growth should continue to drive positive equity returns in which CBs will participate but with much less geo-political volatility and with lower exposure to rising interest rates.

The 150 year-old CB asset class offers investors an opportunity to diversify their portfolios and improve risk-adjusted returns. Historically, convertible bonds have performed very well in comparison to other asset classes: they have delivered equity-like returns offset by less volatility caused by the variance of multiple economic cycles. The embedded equity call option increases the value of the CB when the share price goes up while the bond component protects investor’s capital through a downturn.

The asymmetrical return profile (convexity) is the most distinctive feature of the CB asset class that adds diversification and efficiency to investors’ portfolios – it is the reason why CBs should be considered a part of the strategic asset allocation, rather than a mere tactical play. Further diversification benefits may evolve as a result of the unique credit exposure mix since many of the CB issuers do not have any other tradeable debt. CBs also have short effective duration and therefore are not so sensitive to rising interest rates as the duration of the bond component is decreased by the attached equity option.

It is of paramount importance for CB investors to be selective in order to unlock the full benefits of the asset class and receive the optimal equity return participation and downside protection. Rigorous security selection and credit research are needed to achieve a true asymmetrical balance between potential return and risk.

Convertible Bond Performance vs. Major Asset Classes (1997-2018, 1997=100, USD)¹
Convertible bonds have historically provided equity-like returns with lower volatility and downside protection.

Convertible bonds in a rising interest rate environment
The convertible asset class tends to perform rather well in a rising interest rate environment: in the previous six cycles of rising rates that occurred during the recorded history of the Thomson Reuters Global Convertible Bond Index (since end of 1997), the annualised return of the index registered circa 20%. Monetary tightening usually coincides with a growing economy bolstered by full employment which drives corporate earnings. As a result, equity markets rise and convertible bonds benefit accordingly. The latest episode of rising interest rates started in late 2015 in the US and so far is no exception as convertible bonds have posted strong returns relative to other asset classes but also in absolute terms.

Rising rates could actually be quite advantageous for the convertible asset class as they usually trigger an influx of new issuance expanding the opportunity set for investors. In 2018 the CB investment universe has been benefitting from increased new issuances. In the first six months we have seen over USD 70 billion in new CBs globally – the highest volume in over a decade. The phenomenon is largely attributed to the 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. In fact, US convertible issuance has totalled at about 36% of US high yield issuance year-to-date compared to just 16% in 2017. Notably, over 50% of the new issues have been from first time issuers, which is a record high and shows the significant expansion of the investment universe. Global issuance should remain strong going forward, driven by the US and Europe where a similar trend is expected to emerge following the end of the ECB bond buying programme.

Convertible bonds in a low yield environment
Convertible bond returns are primarily driven by underlying equities followed by spreads and volatility. With potential equity-like upside and bond floor downside, CBs are especially suitable when economic growth is subdued and there is an absence of a strong market trend. Japan provides a real life example of a long-lasting low yield environment where bond returns have been very low and equities have been volatile and uncertain. CBs have navigated through this market well and have been the best performing asset class among equities and bonds for most of the period since the early 2000s. Capturing equity upside and protecting on the downside, CBs are well-positioned for an environment of continued monetary easing and low growth.

Convertible bonds have a place in the asset allocation conundrum
Nobody knows for sure where markets will be heading tomorrow. Economic benchmarks in the developed world remain consistent with positive growth while the escalation of protectionism, major changes in legislation and emerging markets instability remain the dominant sources of volatility. Convertibles should be considered as a solution to bring investors closer to their optimal equity/credit mix. With asymmetrical returns and low interest rate duration, CBs are ideally positioned to efficiently navigate markets that are showing more divergence than previously seen.

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

For more information, please click here or contact NN IP: [email protected]

This is a sponsored article from NN Investment Partners.