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Richard Stutley, CFA | 20 April 2020

Drop the top

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A lot has changed and at the same time many aspects of our lives and work go on much as before. We met last week for our regular round of asset allocation meetings just like we always do, only this time via video link rather than all sat around the desk. One area that looks interesting to us currently is convertible bonds, which in many cases are trading cheap relative to their component parts: the straight bond and the equity option. While convertible cars, or drop-tops, tend to dominate the drawdown phase of most people’s lives, convertible bonds have something to offer in the earlier accumulation phase.

It was a convertible bond issue that reopened Italy’s debt markets last week, following a hiatus caused by the coronavirus and the rising cost of borrowing. Convertible bonds come with an array of different features but in their simplest form they are just like any other bonds, paying coupons at regular intervals followed by the principal at maturity. They can also be converted into a predetermined number of shares in the issuer and the value of this option goes up as the company’s share price rises. Should the share price disappoint, the holder of the convertible still owns a bond with a claim on the business. Convertible bonds pay lower coupons than similar, non-convertible or straight bonds, and the amount of yield given up reflects the value of the conversion option.

The MSCI World index has rallied 26% since the 23rd of March. This may continue – we certainly hope it does – but it is by no means a one-way bet. While focus gradually shifts towards how countries exit from the lockdowns, it remains to be seen who is ready to go back to work and play: certainly not people in the higher- risk age brackets, until such time as a vaccine is developed. The uncertainty over how long it will take for activity to rebound makes convertible bonds appealing to us. As share prices go up, convertibles quickly start to look like equity. As share prices come down, convertibles start to look more like debt. In theory then, convertible bonds have a higher participation rate in equity upside than equity downside and they are attractive when that asymmetry is undervalued.

A convertible bond consists of a corporate bond and an equity option. We continue to like the valuations on credit, although spreads have tightened from their wides following the Federal Reserve’s intervention in the market, and the embedded equity option is not expensive by historical standards, despite the high uncertainty over the outlook for global growth. We like the component parts therefore, and we are happy to see the convertible bonds themselves trading cheap relative to these components. Today many convertibles are trading close to their straight counterparts, implying little to no value in the conversion option.

Convertible bonds are favoured by fast growing companies looking to reduce their annual interest bill by giving away some of their future growth. The current crisis is accelerating trends in online ways of working and consuming, and many issuers in the convertible bond universe cater to those areas. While the extent of this shift in behaviour should not be overstated, we are happy to find ourselves in alignment with it when adding to our convertibles positions.

Convertible bonds have been part of our portfolios for many years. Today they offer many attractive features in our view. They should not be viewed as a panacea, however, and form only part of a diversified blend of different asset classes, which is designed to smooth the investment journey for investors.

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