By Kokou Agbo-Bloua
For many sophisticated investors, talk of the “Great Rotation”, between remaining in apparently plummeting bond markets, and gaining greater exposure to surging equity stocks, represents a slightly simplistic framing of a genuine asset allocation challenge.
Amid the breathless media hype, there are a variety of reasons which make it naïve to suggest that investors will simply exit all bond markets and pour all their funds into equities, in the manner of a casino gambler switching his chips from red to black after seeing a run on red. The nuances of asset allocation, investor goals, economic uncertainty and common sense all militate against such an approach.
Nonetheless, in an economic climate marked by cautious rather than spectacular growth, investors are clearly open to ways of getting equity upside, while maintaining exposure to good credit, and capitalising on interest rate moves and market volatility.
In this climate, we believe convertibles are a particularly suitable vehicle for the improving but still bumpy road ahead.
First, rising cross-asset correlations is now a major headache for investors. Just as the collapse in assets in 2008 was as almost as much of a shock for its synchronisation as its depth and speed, unprecedented central bank monetary policies have increased the correlation amongst equity, rates, credit and volatility to such an extent that managing this new level of correlation is an important part of any portfolio construction.
In this context, convertible bonds provide a unique and underappreciated ‘portfolio effect’ for investors: a relationship between the positive carry from its credit/rates component and the benefits of equity optionality. And the vehicle’s multi-asset portfolio also offers exposure to volatility, ahead of period of sustained market yo-yos as the Fed continues to try to taper back to normality.
This portfolio affect also offers exposure to interest rate upside at a time when interest rates are expected to gradually normalise in the US but will stay low for longer in Europe, especially if ECB QE materialises sooner rather than later as is our expectation at BNP Paribas.
There are other aspects of this portfolio effect. As the IPO boom – aka the Great Flotation – continues to gather pace, it should not be forgotten that most convertible bonds offer change of control features of one type or another designed to compensate the bond holder for his opportunity cost, such as forgone interest income and duration, in the case an issuer is taken over or merges with a different corporate entity. As we expect an increase in corporate activity in 2014, the presence of these takeover benefits is an additional argument for the convertible bond investment case.
Second, the current economic outlook imply a particularly fortuitous period for exposure to convertible bonds. The macro-economic backdrop of subdued but gradually improving growth over the medium term makes the long dated upside calls embedded in convertible bonds relatively attractive, particularly given the low levels of interest rates, and fundamental equity valuation, particularly in Europe.
This environment creates catalysts for further steady credit improvement and continued moderate expansion in P/E, the bedrock of equity valuations. Both these trends benefit convertible bonds. So convertibles are well suited for a grind higher in both stocks and credit, even if this grind has periodic ebbs and flows.
Over the course of 2013, many long-only investors continued to increase their allocation to the Convertible asset class. One reason was heard over and over for this inflow: CBs are an easy way to fulfill a bond allocation but get equity-like returns. This is no doubt an over-simplification but, in an environment where rates are likely to rise (however gradually) and capital is increasingly seeking equity-like returns, convertibles are an compelling consideration.
Kokou Agbo-Bloua is head of Equity & Derivative Strategy Europe at BNP Paribas.
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