Over the last few years investors have been showing increased interest in convertible bonds, attract...
Over the last few years investors have been showing increased interest in convertible bonds, attracted by the potential capital gains and defensive nature of the asset class. In 2007 new issuance of convertibles - corporate bonds that can be converted into a predetermined number of shares in the issuing company at a set price during its lifetime, usually five years - hit record levels, representing some $185bn (£94.3bn), as the asset class became increasingly attractive versus bonds and equities.
Recession fears dominated the market during the first weeks of the year, something we believe is justified, but to some extent overdone.
The drastic 1.25% interest rate cut by the Fed brought some support to the market during the last few days of January. In this period of falling equity markets convertibles provided a shield from share price declines because of their relatively defensive nature.
Typically the rate on a convertible coupon is lower than on a credit coupon, but the investor is compensated with the ability to convert the bond to common stock at a premium to the stock's market value.
In the current falling markets, investors may not want to exercise the option to convert.
Nevertheless, the downside risk of the convertible is limited to the 'bond floor', which is the price at which the convertible offers the same yield as a comparable bond by the same issuer.
If markets were to rebound, convertibles could participate for about 50% in the rise of equities. This means that for each 1% rebound in equities, convertible bonds will go up by about 50 basis points.
On the downside, convertibles have a 30% participation in the decline of equity prices.
Our strategy for the near future is a cautious one. We remain underweight in more risky mandatory convertibles, property and financials.
We expect the Fed to continue reducing interest rates over the next few months, which, added to the US elections, is likely to boost equity markets towards the second half of the year.
- Convertibles are currently attractive compared to equities and bonds;
- The defensive nature of convertibles provides a shield in falling equity markets;
- Convertibles will participate in any rise in equity prices.
By Anja Eijking, manager, F&C Global Convertible Bond fund.
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