Convertible bonds promise the best of both credit and equities and are seen by proponents as the perfect asset class for volatile markets. Despite their flexibility, however, UK pension funds so far remain unconvinced.
Despite strong performance figures and an affinity with bond investment, convertible bonds (CBs) have been considered a nice idea, but not quite right for UK pension schemes. While everyone is entitled to their own opinion, that’s a position difficult to rationalise, suggests Tarek Saber, head of convertible bonds at NN Investment Partners. “CBs are an ideal vehicle to navigate through uncertainty with as they have performed well in numerous investment cycles.” And when it comes to uncertainty, current markets have it in spades. Eight years on from a financial rear-ender, 2016 isn’t going to be any easier for investors to manage. The ongoing effect of quantitative easing, the will they/won’t they about rate rises in the US or any for the foreseeable future in Europe, the presidential election in the United States, Middle East tensions, oil and commodities volatility, potential currency volatilities and wars are just some of the uncertainties that we are aware of, but as usual it is the unknown events that will be the most disruptive. “CBs offer a bridge between fixed income and equity markets,” says Saber. “They have performed well in rising interest rates environments in the past and they have also historically performed well in low yielding environments, as witnessed by what happened in Japan.” Convertibles offer a degree of flexibility that can prove useful in such uncertain markets. They are a hybrid product – a bond that has an option to trade the bond in for a predetermined number of shares in the issuing company. Though the coupon will be considerably lower than a straight bond, what you give up in income is offset by the chance to participate in the potential of that performing well in the future. “Owning CBs allows you to have equity-like participation with half of the volatility,” says Saber. “In the event of there being a bear market you will be more bond-like and in the event that we have an equity rally you will have greater exposure to equities.” NOT PLAIN SAILING So, whatever one’s outlook for 2016, there are good reasons to be bullish on the prospects of convertible bonds, particularly relative to other asset classes, says Maxime Perrin, a senior analyst at Lombard Odier Investment Managers. “In turbulent times, convertible bonds have the capacity to benefit from rising equity volatility and have a strong historic showing at times of rising interest rates.” When interest rate risk is a serious concern, fixed income investors can reduce rate exposure by adding convertible bonds to their portfolios, Perrin says. Then, not only will they help mitigate rate risk, but at the same time increase equity exposure, which he says is a winning combination during periods of rising rates. CBs can also protect against inflation because unlike conventional bonds, they can be converted into stocks and the corporate earnings that underpin the value of stocks can grow in line with – or faster – than inflation. Convertibles have the great advantage of being naturally asymmetrical, says Perrin, through being a hybrid, so when rates are rising during periods of economic growth, equity markets appreciate and convertible bonds benefit. In the event of a serious equity bear market, the value of a convertible bond as a pure fixed income security provides a ‘floor’ to the convertible bond’s price. Of course, Perrin admits it’s not all beer and skittles. The biggest thing investors have to accept is that in any given cycle, CBs are never going to finish first. “You don’t have to win any single stage to win the Tour de France,” says Perrin. “It is only when you are on the Champs Élysées over a full cycle would you benefit from them fully.” By then you will have outperformed a 60/40 equity/bond portfolio, he says, but just as there are protections, until the cycle has run it’s course, in a bull run, you could have been better off in a single asset class. “You need to look at convertible bonds strategically as what they can do from a risk-adjusted reward point of view,” he adds. THANKS, BUT NO THANKS Giles Payne, a director at HR Trustees conceded he sees CBs are a mainstream asset, but not within pension fund investment. “We’re aware of what they can do, but don’t use them at the moment – they are betwixt and between and so we haven’t found any reason to use them.” For anything but the largest schemes as part of diversified growth strategy, there will be a question as to where to put them in the portfolio with an in-house manager, says Payne. This will be a hard decision for trustees, who won’t want to be holding equities in their credit portfolio. That said, Payne can see how DGF managers might use CBs to take yield and yet benefit from the equity upside, but doesn’t see it as a standalone class for the schemes he works with. Pete Drewienkiewicz, head of manager research at Redington, takes a similar view about their application and sees a number of challenges. “The first is that you will likely need a specialist manager and it may not be your first choice or within the most comfortable pools as it will be among the smaller managers. “As a result, they will have smaller funds and they are not very scalable.” Drewienkiewicz is not convinced there are many managers confident of running more than a £1.5bn CB portfolio – though the largest are $5bn and more – so that wouldn’t be attractive to either larger schemes or large consultants. Though he sees an opportunity for smaller consultants, smaller funds won’t be interested in committing 5% of their fund to CBs across one or even several funds.
Convertible bonds offer a bridge between fixed income and equity markets. They have performed well in rising interest rate environments and also in low yielding environments, as witnessed by what happened in Japan.Tarek Saber, NN Investment Partners