Convertible bonds: it’s time to be tactical

Looking ahead, we remain optimistic about the overall economic picture. Synchronised growth momentum is in place and economic growth is proving to be increasingly self-sustaining – a global macro backdrop that should remain supportive of risk assets.

However, this strengthening global growth is setting up 2018 to be a transitional year. With the economic cycle becoming more “late-cycle”, new challenges arise. In particular, the normalisation of monetary policies by central banks – which should lead to higher interest rates in the future – , as well as elevated equity valuations, especially in the US. Combined with lingering geopolitical and policy concerns around the globe, such “late-cycle” challenges offer the potential for higher volatility and greater dispersion risk in equity markets.

Under such conditions, convexity is a key asset. Thanks to their dual nature, convertible bonds allow investors to remain exposed to equity markets’ additional upside potential, while keeping the defensive benefits of the bond floor, on top of relatively lower interest rate sensitivity. Further, were it to happen, a rise in volatility would trigger a positive revaluation of options. As such, investors can expect convertible bonds’ embedded conversion option to benefit from rising volatility in the event of a market correction, thereby partly making up for the detracting equity impact.

By reshuffling the cards between more “static” and more “tactical” strategies – in favour of the latter –, the current late economic cycle strengthens the case for option strategies. However, not all options are equal.

In comparison with listed call options, convertible bonds’ option feature offers key competitive edges. In particular, access to longer maturities (hence the reduced time decay) under relatively attractive pricing conditions (compared with both long-term and “rolled” short-term listed call options). On top of this, a large proportion of convertible bonds embed dividend protection mechanisms, which are designed to alleviate (or even to cancel out) the negative impact of dividend payments on an option’s intrinsic value. This is a powerful argument in view of current dividend yields, especially in Europe.