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Convertible Bonds – a Good Option to Have

Convertible bonds are often overlooked. This brief article provides a refresher on the fundamental characteristics of convertible bonds and an update on our views.
What Are Convertible Bonds?
Convertible Bonds are an example of a ‘hybrid’ security, offering downside protection from their bond component (subject to default risk) as well as participation in equity upside when stocks rally. They have an embedded option, allowing the holder the discretion to convert from the bond to ordinary shares of the issuer, at pre specified terms, including price. The investor also receives a coupon on the bond, although this is lower than that on a normal bond from the same issuer owing to the presence of the option to convert to equity.
Convertible bonds tend to trade at a small premium to the bond market as a result of this embedded option; the value of which increases when the company’s equity performs well and hence it enables the investor to buy those shares below market value. Manager skill comes into play by selecting those issuers whose equity performs well and whose bonds are unlikely to incur a capital loss.

The Convertible Bond Market
As of 30 November 2014, the global convertible bond market stood at $340 billion, as measured by the Bank of America Merrill Lynch Global 300 Convertible Index. This can be broken down as $210 billion US and $130 billion non-US assets. In comparison the global high yield bond market was substantially greater at $2.1 trillion on the same date ($1.4 trillion US and $0.7 trillion non-US assets) as measured by the Bank of America Merrill Lynch Global and US High Yield indices.
Issuance over the year to the end of November 2014 was $77 billion, split broadly 50/50 between US and non-US issuers. This is relatively strong, ahead of 2009 to 2012 levels of convertible bond issuance, but is slightly below the level of issuance seen over the course of 2013 ($93 billion).
How Have Convertible Bonds Performed?
The following chart, showing performance of convertible bonds over the ten years to October 2014 versus that from some other categories of bond investment, presents a number of interesting results. 

Over this period, convertible bonds have outperformed investment grade bonds (bonds issued by firms who are deemed to have a relatively low risk of default) and have been strong in risk adjusted terms versus equities.
Given that the average issuer in the convertible bond universe has a BB credit rating (i.e. below investment grade) we have also compared convertibles with high yield bonds.  The latter have produced better risk-adjusted returns over the last ten years, but have also benefited from significant falls in global bond yields.  We anticipate this to reverse to some degree, so we would not expect high yield bonds to continue to perform as strongly going forward.
When analysing performance over this period we can also see that convertibles have typically captured a significant amount of upside in equity market rallies and participated less in equity market drawdowns. This is consistent with their hybrid nature.
Our View
Their low sensitivity to changes in interest rates stands convertibles in good stead when considered in light of our view that bond yields have further to rise.  That said, high demand over recent years has driven up convertible bond prices so that they no longer appear cheap. Sensitivity to equities is at an historic high, and therefore convertibles offer less protection now against equity market falls than they have in past.
The financial crisis of 2008 has changed the landscape in terms of investment behaviour, and the way investors think about different parts of the broader credit universe has become far less homogeneous in terms of pricing and trading behaviours.  Given the evolution in the market, we now see a clear benefit from investors adopting a more unconstrained approach to investing in credit and believe that an allocation to convertibles could play a useful role in diversifying a credit portfolio. We believe that the best way to access convertibles in this market environment is to ensure that they are part of the opportunity set of equity, bond and diversified growth managers since periodically certain convertibles will offer attractions.
Next Steps
Any decision to utilise exposure to convertibles is dependent on the risk and return objectives that the investor is targeting.  By ensuring that convertibles are part of the opportunity set of appropriate equity, bond and diversified growth mandates, managers who have strength in this sector should be able to dynamically allocate to this market and take advantage of periodic opportunities as they arise.
If you would like to reassess the scope of your current growth mandates, and to learn more about our view on your managers’ capabilities in the convertibles market, please contact your Aon Hewitt consultant or usual contact.
Kathleen MacMillan is a Fixed Income Researcher in Aon Hewitt’s Global Manager Research team.

The information contained above is intended for general information purposes only and should not be construed as legal or investment advice. Please consult with your independent professional for any such advice. The blog content is intended for professional investors only.