Christopher Andrews explores whether UK pension funds could be tempted towards convertible bonds
Convertible bonds are interesting beasts. They have attributes of both fixed income and equities, while not strictly behaving like either asset class, providing a natural hedge that gains value in times of volatility. For pension portfolios, they make sense as a diversifier, and while on the European Continent, America and elsewhere they have a place in pension scheme investment allocations, this is not so much the case in the UK.
As a concept, convertibles started life in the 1860s, as the American railroad industry tried to entice investors to finance what was a
highly volatile enterprise. The idea then, as it is now, was to borrow money more cheaply at the outset, offering lower coupons than standard bonds, in exchange for the option to convert the bond into equity in future. This allows the investor to participate in the company's growth, while providing protection if it goes the other way.
Today the global market is somewhere around $600bn, with 2,300 or 2,400 bonds. These tend to be split between the region of 50 per cent in the Americas, 25 per cent in EMEA and 25 per cent in Asia, Japan and Australia.
Moving on from the railroad, one of the factors which make convertibles interesting as an asset class is the issuer profile. Unlike, say, high yield where investors take on the risk of non-investment grade companies
in exchange for higher coupons, convertibles are really a moveable feast, with a constantly changing issuer profile depending on the economic climate.
"It's not easy to characterise the convertibles market as higher risk
or lower risk or of one shape or another, companies of all shapes
and sizes issue convertibles," says Tom Wills, executive director of the Morgan Stanley Global Convertible Bond Fund. "However, in a period when interest rates are low and it's cheap to borrow money in the straight bond market, it's less common that big established companies will use the convertible market because they can borrow cheaply anyway."
In previous periods of higher rates, the market was more or less split evenly between investment and non-investment grade, but, says David Clott, senior fund manager - convertibles at Aviva Investors, that is probably looking more like 40/60 today. "So there's probably a little more tail risk associated with the asset class than there had been in previous years," he says.
"Of course that can be upside risk as well, so you can probably get some better returns on the upside. On the downside there is probably a little more participation than there was historically, where the numbers say about 70 per cent of the upside and 50 per cent of the downside. You can probably skew that for the future to 75 / 55."
Skewed markets
This mix and match of profiles within the asset class, as well as a lack
of familiarity with it, could make convertibles seem overly complicated, but managers insist this is not the case.
"A convertible is a very simple concept," says Davide Basile, head of the global convertible bond team at RWC Partners. "I'm going to take a lower coupon on the debt, but if the underlying stock does very well I'm going to participate in the profits. That's all it is."
Basile says the level of complexity in convertibles is overhyped, and
this largely stems from the fact that they have been used as a strategy rather than an investment; read hedge funds. "A lot of hedge funds would look at the asset class because there is a lot of quantitative theory behind it, you can make so many different trades, it was essentially the pure hedge - the convertible arbitrage hedge fund. And so I think it got tainted with this level of complexity which is kind of unfair."
Hedge funds tainted the asset class in other ways as well. While they may have injected liquidity into the market, their involvement skewed costs, making them rather expensive for straight investors. Before everything collapsed in 2008, somewhere around 70% of the issuance had
been gobbled up by, often highly leveraged, hedge funds. "When they had to sell that caused an amplified effect in the market, because they had to sell more than the size of their fund," says Wills. "So the convertible market had a lot of disarray in 2008, simply because hedge funds had leverage and they were unwinding their positions."
That disarray, however, ultimately had a positive effect, resulting in a much more balanced market, and the pricing followed suit.
"You had a significant disruption, which really only took two or three months to occur," says Clott. "When hedge funds dominated the market, the pricing became really just focussed for that hedge fund style trade, and for other types of investors there was less opportunity. Now that they have become a lesser part of the market we're much more balanced and new paper is being priced for the outright style investor."
What's it really good for?
As an outright style investor, pension scheme trustees could find themselves asking 'what's the point?' If this is a bit of equity and a bit of
fixed income, why not avoid all that perceived complexity and just invest outright in stocks and bonds? There are several arguments here.
First, when you buy a convertible you don't own stock, you own options on shares, which means if the stock is doing badly you don't have the same downside risk. And again, options are more valuable in times of volatility; Wills compares it to owning insurance when there are fires and floods raging everywhere. "So in a volatile market period, like say the last 10 years, owning the option will have in many cases proved to be better than just owning the stock, because that volatility is something that is an asset unto itself."
That optionality also tends to be long dated, so is really the only way to have exposure to long-term call options. "Then you tend to have convexity in convertibles, to a degree, because of this long dated option," says Basile, "and what that means is that the convertible profile can change quite quickly."
In the convertibles space, 'delta' is the measure of sensitivity to equity price movements. Because of the bond component and the optionality, if an underlying stock goes down, the delta moves down, meaning you rapidly achieve the bond component. "That means if you have a convertible portfolio and markets go down, because of the convexity, your participation to the equity market moves down quite quickly. So you tend to have a product which automatically adjusts its asset allocation," says Basile.
Basile says this as like having a daily asset allocation meeting, as
the convertible portfolio reacts automatically to the changing market. "If markets are rising, your participation on the way up is increasing, if equity markets are decreasing, your participation on the way down is decreasing," he says.
Convertibles also have diversifying effects in the context of portfolio construction, says Peter Meier, convertible bonds portfolio manager at Swisscanto. "But beside that they also offer a kind of equity "crash protection". This is especially true if you focus on investment grade convertibles. The quality of the bond-floor should remain intact even in a bad market environment."
All in?
For those including convertibles in their portfolios, the standard allocation tends to be somewhere in the region of five per cent. There may, in fact,
be a mathematical case for higher allocations but supply is a big constraint here.
"The convertible market is not the largest out there," says Clott. "So you do have an issue with regards to how much you actually can allocate to the asset class."
The market is expected to grow as rates globally move higher, and then it could be feasible to allocate a larger proportion, he says, but at this point it would be difficult. "If every pension fund which invested five per cent in convertibles were to raise it to 10 per cent it would be problematic for the market, it would be too much demand. Right now the supply and demand is relatively balanced."
How that balance would change if UK pension fund investors got interested is another question, but it seems something of a moot point at the moment. While convertibles are hardly new, pension investors in the UK are really still only testing the waters, and there are a few potential reasons for this which don't seem to be going away.
First, the convertible story is a global one, as limited issuance
means focusing on a single region will tend not to provide enough diversification. UK pension funds have traditionally been home biased to
one degree or another, and a focus purely on UK issued convertibles wouldn't work at all; there just aren't enough of them.
This lack of issuance also means that UK investors are less familiar with the asset class generally, according to JP Morgan Asset Management's Olivia Mayell. "You've had a lot of European issuers in the past, and so the corporates are often familiar with it. The UK has had limited issuance, and it hasn't been as popular an asset class for any investor really. But over the past few years people have become more familiar with it."
Mayell says that Europe is also a more fixed income-centric market, with heavier weights to fixed income generally, and so convertibles have been a natural extension from that, as their divergence from normal
bond behaviour makes them a good diversifier.
"The UK has been a more equity centric environment, and so convertibles just look like boring equities," she says. "Where if you see them as exciting fixed income then maybe the debate is a little bit different."
Christopher Andrews is a freelance journalist
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