By Beat Thoma
We are living in unprecedented economic times. The threat of the Grexit seems more likely with every passing day, political instability in Eastern Europe continues to dominate the headlines and on-going volatility in oil prices is continuing to distort markets. Increasingly worrying is the fact that this economic opera is being played out against a backdrop of growth much flatter than that seen in previous economic cycles and on a stage where the traditional buttons of fiscal stimulation have all been pressed. Put simply we are in unchartered and dangerous waters.
But the world continues to spin on its axis, the sun continues to rise and fall and investors continue to remain under pressure to deliver returns. How then can then navigate this difficult terrain?
Firstly, not all is bearish. Equity markets continue to perform robustly and are seemingly weathering the uncertainty that surrounds them. Moreover, credit remains cheap due to record low-interest rates and quality high-growth companies are able to readily access finance. Understandably investors want to take advantage of these fundamentals but when the margin between economic confidence and fiscal meltdown continues to narrow, the potential for asset misallocation is grows.
Now more than ever the ability to access downside protection is crucial and preferably at a relatively cheap price. Thankfully for investors, recent dynamics in the convertible bond market are providing exactly this opportunity. One only has to look at the success of the $1.6bn issuance by Uber to appreciate that, at least amongst some investors, the asset class is well-understood and its properties in uncertain markets valued. Providing investors with the opportunity to benefit from share price upside in a rising equity market and downside protection through the bond element, they are a powerful tool in any investment portfolio.
In the UK however, convertible bonds have remained regarded with scepticism. For companies they are seen as a complex way of raising funds, particularly in such a low-interest rate environment, where traditional finance comes cheap, whilst for institutional investors their technical nature means they are often eschewed. However, with implied volatility rates now hovering between 28 and 30 per cent and trending slightly below the long term average of 31 per cent, investors may well be grateful for the relatively cheap downside protection they currently provide access to.
Like all investment decisions they require detailed analysis and a robust decision making framework. For convertibles this is typically a multi-stage process analysing both the fundamental credit risk, optionality in terms of puts or calls as well as the underlying equity and its exposure to macro-economic or sector trends. Active management is also crucial given the fact that their risk return profile can vary substantially over time.
Importantly, for investors the asset class continue to evolve and sophisticated tools have now been developed to in order to make them more accessible. One can only hope that such innovation will put an end to traditional criticisms such as how risk should be modelled or where the asset class should sit within a portfolio, leading to wider acceptance and injecting even more liquidity into the market.
What cannot be denied is that in such turbulent markets, convertible bonds should not be ignored. Ignorance is no longer an excuse, particularly as the search for yield intensifies and pension scheme deficits continue to be a boardroom issue. As the future of the global economy continues to hang in the balance and with future growth trajectories far from certain, it is a brave investor who turns his back on an asset class capable of providing downside protection should the economic engine stall and a financial tailspin ensue.
Beat Thoma is chief investment officer at Fisch Asset Management
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