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Convertible bonds: Protection through the bond floor

Convertible bonds: Protection through the bond floor

The relatively novel market for global convertibles created by Mifid rules on bank capital faced its first real test at the end of 2015.

Questions about the solvency of Deutsche Bank were enough to knock the Thomson Reuters CoCo Index euro 12%, as investors focused on their capital at risk.

Just over a year on from that low and investors have recovered their poise, and returned to judging sector risk on the upside participation they are able to buy versus corporate bonds. The Thomson Reuters index has recovered almost all its losses, rising to fractionally below its previous high.

Corporate issuers beyond the banks which have driven issuance in recent years have not failed to take note. According to financial analytics firm Dealogic, in the US, 34 companies sold convertible bonds in the first months of this year, raising around $11.1 billion (£8.65 billion).

The majority of convertible bond issuers tend to be growth-orientated companies. Among the big issuers of convertible bonds in the first part of this year have been major technology companies such as Tesla and Twitter founder Jack Dorsey’s company Square, which manages mobile payments.

If the price is right, convertible bonds can make sense for both companies and investors.

Jo McCaffrey, head of international product at State Street, says with the current equity rally, now is a good time for companies to issue convertible bonds.

‘As issuers of convertible bonds, it’s an interesting time to issue – you’re giving away an option, but there isn’t that much space in the equity market for people to exercise that option, so it’s a really good way of funding.

‘Convertibles tend to have a slightly lower yield than a normal corporate bond. So as a company coming to the capital markets to help fund yourself, you’re getting a slightly lower funding rate. You’re not super exposed to where the equity market it is at the moment.’

But for investors, she adds that the bond floor offered by convertibles can add protection while also allowing them to participate in the equity upside: ‘We call it an asymmetrical return because you capture some of the equity upside but you’re cushioned on the downside, as you have a protection through the bond floor.’

Capturing upside

Nathalia Barazal, head of convertible bonds at Lombard Odier, says in the short-term convertibles can capture between 40-70% of the upside of equities, and would usually lose between 20-50% on the downside.

Meanwhile, in its outlook for global convertible bonds in
2017, Schroders said well-structured convertible bond strategies have been shown to participate in around 75-80% of the equity upside.

The firm added that 2017 will be a year where ‘protection becomes an important feature’ for its investors’ asset allocation with volatility expected to come back to equity markets.

For McCaffrey, this is where convertible bonds come in: ‘If you think where we are in the macro environment, there is still a lot of volatility available in the market, so investors are also trying to think – I want to participate in this euphoric equity rally we’ve seen, but I’m still worried about these sharp sell-offs, tail risks, and black swan events.

‘Convertible bonds give you a way to do that, because they give you that cushion.’

Despite the protection offered by convertible bonds, along with the chance to participate in the equity upside, the big concern for investors when it comes to convertibles has always been around liquidity.

McCaffrey admits convertibles do tend to be less liquid than plain vanilla bonds and can sometimes be more expensive to trade due to their sensitivity.

She says: ‘If you think about how liquid and how actively traded the options market is, and the sensitivity of options to what happens in the world, options tend to be pretty sensitive. When you combine that with a corporate debt instrument there is more sensitivity there to price movements, so they can be more volatile than a standard corporate bond. Not always, but there are risks to it.’

But according to Barazal, investors should be more concerned when it comes to other types of bonds: ‘Liquidity has always been the talk of the town. The real liquidity issue is not in convertibles, it is elsewhere in the bond markets.

‘We usually trade with around $300 to 500 million a month. If you think liquidity is poor, we still manage to trade. It’s not like liquidity is non-existent. It’s something to be aware of, but it’s not worse than other asset classes.’

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