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Alex Harvey, CFA | 05 October 2020

The Perfect Storm

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If readers cast their minds back to February this year, they will remember the horror that unfolded on the high seas with dozens of cruise ships being forced to stay at sea as the first wave of Coronavirus took hold. The poster child for the industry was the ‘Diamond Princess’, a Gem-class cruise ship with a capacity of nearly 2700 passengers and 1100 crew, which eventually anchored at Yokohama port in Japan where passengers had to remain on board and self-isolate for several weeks. The world watched on thinking perhaps this would be contained to Asian shores but of course this was wrong as we now know. Global equities would continue to make gains for almost three weeks after the cruise liner had docked before freefalling, only to reach a bottom just over a month after that. Far from plain sailing.

These ‘floating petri dishes’, as they became known, also inadvertently shone a light on an asset class that we at Momentum have long favoured owning in our multi asset portfolios: convertible bonds. We have written about these before – most recently in April - but following strong performance they warrant further praise. These types of corporate bonds are more complex than their ‘straight’ bond equivalents, but it is worth spending a few moments to consider their attributes and what they bring to an investor’s portfolio. In its simplest form, a convertible bond is a corporate bond with an embedded call option that allows the bondholder to convert the debt into equity if certain conversion criteria are met. The effect of pairing a call option with a corporate bond is that if the underlying equity goes up, the bond behaves more like equity; if it goes down it behaves more like a corporate bond. This ‘convexity’ effect – which extends to a portfolio of convertibles - thus plays a useful and impartial role in self-allocating into and out of risk as equity markets rise and fall.

Convertible bondholders may earn a coupon, but it is usually lower than that which would be paid on the straight bond equivalent as the equity option acts as a sweetener. It is why convertible bonds can be attractive to issue for higher growth companies who may not generate enough cash to service traditional debt and who often prefer to recycle earnings into the business. By the same notion, convertible bonds can prove to be a lifeline to an imperilled business needing a capital injection. Step in Carnival Corporation, the global operator of 10 cruise line brands. When the business hit the proverbial reef earlier this year, they needed to raise cash quickly to help finance the ~$1bn a month needed to stay afloat, literally. $4bn of the $6.25bn raised came from a straight bond paying a whopping 11.5% coupon while $1.75bn was issued in 5.75% convertible bonds (and the rest from a watered-down equity raise). Issued at $100 the convertibles traded up to nearly $260 and now rest closer to $170. At the same time, the 11.5% coupon bonds traded up from $99 to $112, while the equity has marched nearly 80% higher since the two bonds were issued in early April. With the convertible bond sharing in almost all the equity upside it has been the clear risk adjusted winner of the three.

At a broader level, a portfolio of global convertibles has also performed remarkably well year to date. They suffered less than half the drawdown of global equities in March, yet have tracked almost one for one on the way back up as expectations of higher volatility (which serves to make the embedded option more valuable) and a flood of cheap issuance has supported the asset class. At Momentum, we can use asset classes like convertibles to improve the journey for our clients, investing with several small but well-established teams in this somewhat niche and underrepresented asset class. We owned these types of bonds at the start of the year, added on several occasions after markets bottomed, and continue to favour the asset class today given the richness in some sectors and potential uncertainty that lies ahead. For convertible bonds these are not uncharted waters. While they are not risk free assets, they should provide ballast if and when the next storm whips up.

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