What’s driving convertibles in 2023?

Raina Dunkelberger, CFA, CAIA, Investment Director
Michael Barry, Fixed Income Portfolio Manager
2024-01-31
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The views expressed are those of the authors at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional, institutional, or accredited investors only.

2022 was a disappointing and unusual year for risk assets. Convertible bonds were no exception, as both the equity market sell-off and fixed income headwinds – rising interest rates and widening credit spreads – worked against the asset class. On the equity side, convertibles’ large exposure to growth sectors (such as technology, biotechnology, and medical devices) exacerbated the struggle, as many such stocks significantly underperformed the broader market last year.

If 2022 was dominated by macro factors (such as interest rates, Fed policy, and energy prices), then we believe 2023 will be more about companies’ fundamentals driving convertibles’ performance and allowing for greater differentiation among individual companies and the sustainability of their business models. Additionally, we expect three key tailwinds to help further drive the asset class this year.

1. Lower delta, higher yield

Going into 2023, nearly 50% of global convertible bonds were trading at or very close to their bond “floors,” with what is technically a “free”-equity option1. As shown in Figure 1, both global and US convertibles’ market deltas2 were recently trading well below their long-term historical averages, essentially making the entire asset class more “bond-like” in nature, with much higher effective yields than usual. This is important because buying convertibles with higher yields may allow investors to be “paid to wait” for a better economic backdrop and/or improved corporate financial strength. Those conditions, in turn, would likely lead to tightening credit spreads that could help boost the performance of many convertibles, especially given their “uncapped” upside potential.

2. The return of the primary market

2022 witnessed the fastest pace of interest-rate hikes by the US Federal Reserve (Fed) in the last 15 years, which brought most of the fixed income new-issue market to a halt. Following that cycle, we expect primary bond market activity to more or less return to normalcy in 2023. Historically, corporations have often chosen to issue convertibles, rather than traditional corporate bonds, in an effort to minimize their interest expenses. That was often not the case amid the ultra-low-rate environment that characterized the post-global financial crisis era. Starting last quarter, however, we seem to have entered the early innings of a renewed trend toward many corporate issuers tapping the convertibles market for their refinancing and operating liquidity needs.

3. A pick-up in corporate activities

With convertible bond valuations now much lower as of this writing (see above), it is only natural for companies to again consider repurchasing their own securities, which would result in organic de-leveraging for many such companies. Similarly, last year’s dramatic equity market sell-off pushed many companies’ stock valuations to near historically low multiples, making them potentially ripe take-over targets for other firms. With that in mind, we think convertibles, with their generally large exposure to early-stage growth companies, look well positioned to benefit from a potential rebound in merger-and-acquisition (M&A) activities.

Bottom line on convertibles

We believe investing in convertible bonds presents an opportunity for allocators to:

  • Participate in an eventual equity market recovery, with a lower risk budget than most direct equity investments require;
  • Earn positive, potentially attractive yields from convertibles’ coupon payments, particularly post the recent Fed rate hikes (see above);
  • Likely benefit from future credit spread tightening, while also adding convexity and enhanced diversification to their portfolios.
Figure 1
whats-driving-convertibles-in-2023

1A convertible bond valuation is typically determined by the value of the bond “floor,” plus the embedded equity call option. The bond “floor” is often valued as the net present value of the expected future cash flows. The equity call option’s valuation is a function of the underlying issuer’s stock price relative to the option’s strike price, the underlying stock’s volatility, the time to maturity, the unprotected dividend yield, and the interest rate. | 2Delta measures the equity sensitivity of convertible bonds, calculated by the ratio of the change in prices of convertible bonds to the change in prices of the underlying stocks. Higher delta indicates greater equity sensitivity.

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