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Global convertibles: Unprecedented times call for unconventional solutions

Raina Dunkelberger, CFA, Investment Director
Michael Barry, Fixed Income Portfolio Manager
2022-11-30
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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.

Across most asset classes, it’s fair to say that the first seven and a half months of 2022 have tested investors’ patience and resolve. For many, today’s high-inflation and rising-interest-rate landscape is uncharted territory that may call for some unconventional investment solutions — an allocation to global convertible bonds, for example. 

In our April 2022 blog post, Global convertibles: Poised to benefit from five structural tailwinds, we made a multipronged case for investing in convertibles that we believe still holds true in many respects. Thanks to their hybrid stock/bond nature, convertibles may help investors weather today’s challenges and uncertainty, while providing opportunities to diversify their fixed income portfolios and still maintain a foothold in the equity market.

Here's our latest outlook for global convertibles, broken out into five distinct vectors, followed by our “bottom line” for the asset class as of this writing.

1. Macroeconomic climate

Negative. Global central banks continue to tighten monetary policy in an effort to combat persistent inflationary pressures. In particular, the US Federal Reserve (Fed) appears committed to its current rate-hiking cycle, while the European Central Bank (ECB) has decided to end its asset purchase program and to commence rate hikes of its own. While we now anticipate a central-bank-induced global economic slowdown, we do not envision widespread defaults to come, given the strength of corporate balance sheets and the lack of similarities to past default cycles.

2. Corporate fundamentals

Neutral. Balance-sheet quality and measures of corporate liquidity generally remain healthy, but we expect some bond issuers to experience profit-margin compression in the near term. In addition, the increased frequency of both earnings “misses” and reduced earnings forecasts has been reflected in market pricing. The environment looks ripe for M&A activity, from which many convertibles can potentially benefit because of their equity-upside participation. The asset class offers exposure to a number of “secular winners” and industry leaders.

3. Market valuation

Fair. In our view, the positive convexity1 of convertible bonds is a valuable feature in today’s market setting, especially given the relatively longer duration and negative convexity of other fixed income sectors. Overall market valuation, as measured by average discount to par value, remains inexpensive by most standards. Global convertibles’ valuations are now around their historical median, providing potentially attractive entry points for longer-term-oriented investors.

4. Market technicals

Constructive. Several macro factors — elevated market volatility, stubbornly high inflation, and rising interest rates — along with low new issuance volumes for global convertibles year to date have all contributed to what we see as a favorable technical market backdrop for the asset class these days. 

5. Default risk

Constructive. As noted above, we are not concerned about an impending wave of corporate defaults infecting the convertible bonds space. Default rates may tick up slightly in the period ahead  but are likely to stay below their long-term historical average of around 2% for the next 12 months or so (Figure 1).

global convertibles unprecedented times call for unconventional solutions fig1

Bottom line on global convertibles 

We think investors should brace for the prospect of further periodic bouts of global market volatility, including in the convertibles market. With that in mind, skilled individual security selection is likely to remain key to successfully navigating the sector. Specifically, we believe a focus on "quality growth" names with competitive advantages like recurring revenues, ample free cash flows, and secular tailwinds may serve investors well going forward.

1Convexity is a measure of the curvature, or the degree of the curve, in the relationship between bond prices and bond yields. If a bond's duration rises and yields fall, the bond is said to have positive convexity.

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