Can you be converted?
There is a US$550 billion ($764 billion) market that is rarely considered by Australian investors. Convertible bonds (CBs) are barely used locally, while in the US and Europe these are a key component of a growing company’s capital and pension fund portfolios.
To appreciate this market, we must consider why CBs make sense for an issuer. Assume a company has expectations of high growth and therefore capital requirements to fund said growth. Its options are to issue equity before the growth has been achieved, and thereby dilute current shareholder returns; or raise expensive credit/debt, likely in the high-yield market, as these companies have not yet established their investment-grade credentials. Alternatively, a company may be experiencing a temporary downturn and requires capital, but again faces unattractive equity and bond pricing.
The convertible bond option offers answers to each of these companies. A modest coupon or interest payment (below comparable credit markets) is combined with an equity call option, priced to assume that growth potential is achieved.
It is therefore unsurprising that this market is dominated by information technology, communication, consumer discretionary and healthcare companies. Regional differences play a role too. One of the defining characteristics of each bond is its ‘delta,’ or the relationship between the price of the CB and the underlying equity. A delta of 100 means that the two are tracking in unison. The US CB sector has a higher delta (as at June 2020, 73) reflecting its equity-like growth, than Europe (delta of 40), where the issuing companies tend to have less operational and balance sheet leverage, representing higher bond character. Asia is another version (33 delta), given the relative newness of the companies that offer CBs, with China growing to dominate that market.
The Thomson Reuter/Refinitiv Index constrains the representation by excluding perpetual securities, maintaining a threshold size and excluding issuance with near 0 or 100 delta, to retain the balance between bond and equity representation. This matters as there can be meaningful skews. Tesla, by way of example, accounts for more than 10% of the US CB market and is therefore dialed-down in the index.
According to the Global Convertibles Team at Lazard Asset Management, Tesla Inc. is a unique case study in the convexity of the sector. After issuing a convertible bond in March 2017 the stock fell by 30% into June 2019, with the convertible falling far less: just 4.6% down. Exhibiting the convexity of the asset class, with the share price now up over 877%, the convertible bond closely tracked the result, delivering a 721% return.
Using the index nonetheless exposes an investor to varying equity/bond risk depending on the nature of issuance at any time (taking into account the circa five years before average conversion). Recently there has been an upsurge in ‘rescue ‘ CBs issued by airlines, cruise operators and retailers. Active managers like Lazard target the delta, avoiding overly high correlation to equity and cyclical exposure. The mantra is to provide some defence in a drawdown, while participating in equity rallies.
The historical performance of the CB market requires consideration. While the sector has delivered over 5% per annum in the last decade, active managers have neared double-digit returns throughout, benefiting from the information asymmetry in predominantly smaller company sector. In 2008/09 its defensive intentions were undermined by large hedge fund holdings being sold under stress. Today, hedge funds only account for 20%-25% of holders. Late 2015 also saw weak performance as energy stocks tapped this market in the overheated US energy boom. The converse was the case in 2018 when CBs handsomely trumped equity returns, due to the high weight in IT and consumer staples.
Over the past year the sector has performed very well, up 14% in US$ terms to end-July, with Lazard adding as much as 18% over the same period. The attraction has been the industry mix, but also the straddle between equity and bond characteristics. Each active manager can clearly spell out its view on equity risk and recast its portfolio towards downside protection or upside participation. The question is, where does it sit within a portfolio? Carrying both equity and bond like characteristics, is defensive-growth equity an option? That can be claimed without spin, particularly in a zero-rate, high-valuation environment.