Key points
- With already two interest rate hikes in only 3 months in the US and more to be expected this year, investors are looking for alternatives to their bond investments.
- When faced with a rise in interest rates, convertible bonds’ embedded option acts as a safety cushion, partially offsetting the negative impact on the bond component.
- History has shown that when rising interest rates was paired with ad-ditional equity performance, convertible bonds could not only deliver positive performance but, in some cases, even outperform equities.
- The ECB’s extensive asset purchase program has pushed prices upwards in credit markets across Europe. In contrast, convertible bonds have remained preserved from this massive distortion effect.
- Although a tightening trend has also started in the convertible space, at current spread levels, they still have much higher value potential to offer than comparable straight bonds.
- Over the past months, the combination of convertible bonds’ key differentiating features has enabled them to significantly outperform straight bonds.
- We believe this is only the beginning.
The beginning of a trend
As widely expected, the Fed hiked its key rates by 25bps during its March FOMC meeting, on the back of recent solid equity markets’ performance, firming growth indicators and rising inflation data. On this occasion, the US Fed chairman, Janet Yellen, reiterated that further increases should be expected this year.
While this is more imminent issues for US investors, European fixed income markets are not immune to the risk of rising interest rates. As indicators and growth outlook continue to improve in the Eurozone, an appeasement of political risks could lead the ECB to adopt a more neutral monetary policy stance over the course of the year, with a possible shift in communications over the summer months. On April 27th, while keeping rates unchanged, ECB President Mario Draghi yet acknowledged the vigor of the Eurozone economy.
For investors looking for alternatives to their bond investments, current environment points towards convertible bonds.
An efficient hedge against rising interest rates? History points the way
When faced with a rise in interest rates, convertible bonds' embedded option acts as a safety cushion, partially offsetting the negative impact on the bond component. This comes from the fact that equity options are positively correlated to interest rate moves. As such, they usually provide positive returns when interest rates rise.
Looking back at periods when the yield of the 10Y-Bund (in Europe) or of the 10Y-US Treasury soared by more than 120bps over the past 20 years, figures speak for themselves. During each of these 11 periods (3 in Europe and 8 in the US), not only convertible bonds outperformed systematically straight bonds but they were also systematically positive whereas straight bonds were systematically negative in absolute terms.
History has shown that when rising interest rates was paired with additional equity performance, convertible bonds could not only deliver positive performance but, in some cases, even outperform equities.
Nicolas Delrue
Head of Investment Specialists &
Convertible bond Senior Investment Specialist
Scarlett Claverie-Bulté
Convertible Bond Investment Specialist