Stock-like performance with fixed income stability

Convertible bond issuances have hit record levels in 2021 so far, with more than $45 billion of the assets issued in the US alone by the end of May, says Lazard Asset Management’s Arnaud Brillois, CFA.

This enthusiasm on the part of issuers – corporates from a broad range of sectors and company types, including some at the more tenuous “growth” end of the market – has been matched by investor demand. But as the portfolio manager of Lazard’s convertibles team said in a recent interview, it’s crucial for end-investors to understand the fine print before opening their wallets.

As with most fixed-income assets, convertible bonds (CBs) aren't generally well understood by retail investors, which is why Brillois delved into them in a recent podcast interview. He explained some of their key features, prominent differences between the vehicles in different parts of the world and why they’re often issued by growth companies - and sometimes by companies that need to raise funds cheaply and quickly.

How should investors think about convertibles?

“First, you have to know that the convertible bond is a simple and standardised product. But foremost it is a bond," says Brillois, highlighting the following features:

• Maturity – The date at which final payment on the vehicle is due, when the instrument matures.
• Coupon – The annual interest rate paid on a bond
• Yield to maturity - the total return anticipated on a CB if it is held until the maturity date.
  
• Strike price – the price at which the holder can convert a CB into a stock.

"Even if the equity has been rising, it will often be more appealing to convert it in order to get a stronger return. But if the equity has been falling, you can ask to get the cash back and to halve the coupon,” says Brillois.

Explaining one of the key regional differences, he points out that CB premiums are close to 25% in the US, while in Europe it’s closer to 35 or 40%.

On the other side, you have a yield to maturity.

“It would systematically be a bit smaller because there is no free lunch. When you buy a convertible bond, you buy the option to convert, so as a consequence, the coupon and the yield to maturity will be returned at a lower point,” Brillois says.

“Indeed, in the current market, yield to maturity is between 0.2 and 2%, depending on the rating, maturity and what the issuer wants to do with the convertible bond.”

As Brillois explains, around three-quarters of Lazard’s retail investors think of CBs as bonds, while around 20% think of them as equities – particularly those who are quite conservative in their investment approach. “And around 5% are the ‘true believers’ in convertible bonds and have a specific allocation to the asset class.”

Why do companies issue CBs?

The appeal for growth companies is that the CB structure enables them to raise equity in their company at a far lower price than they could by issuing equity. This is also the reason companies in distress often opt for these vehicles, as we saw soon after the COVID downturn in March and April last year when many travel companies issued CBs.

For example, Singapore Airlines tapped debt markets last year, issuing US$4.6 billion in CBs to mitigate the damage inflicted by COVID travel bans – after reporting a record annual loss of US$3.2 billion.

“Around 60% of CBs are issued by companies that are growth companies or mid-caps. It has always been the case and it is one of the specificities of the convertible bond universe,” says Brillois.

Though the US is by far the biggest market for CB issuance, they’re also big in Europe. And issuance of CBs in Asia is rising fast. This region had started to build pre-pandemic, and Brillois expects it will pick up again from next year.

“I think there are currently around 37 Chinese Companies that have been seeking regulatory approval to issue convertible bonds, so we believe the primary market from Chinese companies will be very strong, just as the US market will continue to be strong.”

Brillois also offers an explanation for the regional differences in the way issuers – and investors – think about CBs. He says many European investors have an inbuilt reticence when it comes to equity markets, so often prefer these lower-risk vehicles.

On the other hand, a more adventurous approach in the US means investors lean hard on the stock component of CBs, “so they will push the convertible bond for the smallest premium to be ‘in the money’ as fast as possible."

“It has always been the case, that’s not something that’s a recent change, it’s in the DNA here, just as European investors want more protection.”

When volatility strikes…

…Is often the best environment in which to invest in CBs, says Brillois. “The higher the credit spread level (the difference between the sell and buy price), the higher the quality of issuers who will choose convertible bonds compared to a normal high-yield bond, just to decrease the cost and the refinancing rate.”

Lazard manages risk in its convertible bond portfolio by focusing initially on the bond component, which it needs to be strong enough to sustain value even if the company’s equity price declines to a certain level.

“There is nothing worse than buying a convertible bond when the equity price declines at the same time as the bond component is going down – that’s a convertible bond that won’t protect you, so we’re quite conservative on the credit component,” Brillois says.

“And on the equity exposure, which is one of the most important drivers of performance, we are a buyer of volatility, but we’re also sensitive to this.

“A CB will increase in value when the underlying equity shows a high level of volatility because the probability that it will be ‘in the money' is higher.”

“We spend a lot of time on the underlying equity, the bond part, on the asymmetry or convexity in the way the convertible bond is going to react to the market,” Brillois says.

Look out for unusual provisions

He singles out conditions that are sometimes buried in the PDS of CBs, known as “collar clauses," as features investors should look out for. Some of these kick in one or two years after a CB launches and are a way for an issuer to protect themselves if a stock price is climbing too quickly.

In these cases, the issuer can trigger the cause and claw back the convertible bond, “but it means that you’ve made a lot of money anyway, because it is usually triggered only when the underlying equity has been going up around 30 or 40%, so when the issuer is panicking and is afraid the CB is going to cost too much in terms of debt,” says Brillois.

What can go wrong?

Casting his mind back to 2008, Brillois recalls the selloff in CBs during the GFC.

“When credit spreads were widening at the same time that equity markets were going down strongly, it affected both the bond and equity valuations of the CBs,” he says. This led to some severe liquidity issues during the GFC.

Another risk he singles out is weak primary markets for CBs, which means they can become much more equity-like in their characteristics. This occurred in 2005-2006 when low volatility in equity markets meant that the valuations of CBs decreased substantially.

But overall, CBs are generally regarded as attractive investment vehicles at the various stages of a market cycle.

“They’re a lot less sensitive to market timing than stocks, and over the last 20 years, even when interest rates have been increasing, CBs outperformed strongly,” says Brillois.

“This is because of their equity component and the strong primary market that systematically renews the different sectors and the convexity of the asset class.”

“Like having kids”

For the above reasons, Brillois believes 2021 and 2022 will be very good years for the asset class. But he urges investors not to buy such assets “over the counter”, emphasising the large amounts of time and expertise required to buy, hold and trade them successfully.

“Go for the funds. Buying CBs directly requires you to watch them all the time, not only because of clauses but also conversion”

“CBs have to be watched to know when to convert, when to keep your money and when to ask for a full cash redemption,” says Brillois.

“If you invest in CBs, it’s like having kids: you have to watch them all the time.”

Learn more

The Lazard Global Convertibles Fund is an actively managed convertible bond portfolio that typically holds 60 to 80 convertible global bonds selected from a universe of approximately 1,000 securities. For further information, please visit their website, or use the contact form below.