Fund Buyer Index

Convertible bond sentiment reaches low

Posted in Feb 2019
by Jassmyn Goh

Demand from fund selectors for convertible bonds dropped in the last quarter of 2018 but some argue that buyers could use the asset class as a form of protection.

In Q4 2018 13% of continental European fund selectors were looking to increase their allocation, according to Last Word Research. Another 29% looked to hold, 12% to decrease, and 46% did not use the asset class.

In terms of popularity, out of 26 asset classes convertible bonds dropped six places to 15th most liked from Q3.

“Plenty of respondents do not use the asset class, especially in the Nordics,” the research found.

According to Morningstar data, in 2018 the asset class experienced €3.6bn in outflows, and only four months in 2018 saw inflows.

Bonds are risky

Apo Asset Management lead portfolio manager, Marc Momberg said he is looking to reduced his convertible bond by between 35 to 50%, mainly in European convertibles, over the 12 months to December 2019.

“We decreased our allocation over the last few months as we considered a 40 delta on the convertible bonds too high,” Momberg said. Delta is a measurement of an option’s price sensitivity to a given change in the price of an underlying asset, so, if the delta is 40 specific option contract, for each $1 move the option price may move by $0.40.

“We did not want to take on that risk on the bond side for now, as we see some weakness in the economic data, especially in Europe and we expect Trump to turn on Europe next after cutting a deal with China. That could further derail the markets, at least temporarily.”

Momberg noted that he still wanted a foot in the convertible door to keep long term relationships with managers which would “secure good conditions for our clients on the funds we invest in”.

He noted that some of the money that was taken from his convertible allocation went to a shorter dated US Treasuries exchange traded fund for yield and to reduce a US dollar underweight.

“We also increased our position in a very active European equity manager, who currently holds 30% cash,” he said.

“We went more into pure plays – which is generally something we like to do when uncertainty increases. That way we have better control of the risks, which might hit our target investments.”

Using convertibles for defence

However, Titus Gesellschaft für Finanzdienstleistungen’s managing director, Stefan Schrader said he was looking to increase his allocation as a defensive strategy against geopolitical and financial market issues such as the US-China trade war, Brexit, Italy’s economy woes, and the unmoving interest rates.

“Convertibles in my opinion have an extra premium especially in these confusing market conditions,” he said.

“There is more upside in the market this year and convertibles will work with the upside and give protection on the downside.”

NN Investment Partners head of convertible bond strategies, Tarek Saber, said bearish investors who potentially believe that there will be a recession this year could take some of their equity risk off the table through convertible bonds.

“If they’re wrong [about a recession] they can still participate in the upside,” he said. “If they’re right and we end up in a bear market then they will have what I call balanced convertible bonds with convexity.”

For the bullish investor, Saber said investors looking at Europe should be careful which companies to invest in as some will benefit from how well the country did.

“Allocating anything between three to 10% to ‘converts’ will give you diversification to reduce risk,” he said.

Misunderstood

Saber noted that there was a “misplaced fear bordering on phobia” towards convertible bonds and there needed to be more education on the asset class.

“When used properly it (a convertible bond) has fantastic benefits but when it’s misused, leveraged up and unintended risks are made, that’s when it bites them and then they blame the tools rather than their recklessness,” he said.

“Another thing I have come across is when things have career risk people tend to shy away from them unless they’re forced to look at them and potentially get involved,” he said.

Saber said a lot of firms, post-2008, did not accept complexities in prospectuses such as dividend protection which hedge funds pre-2008 were very comfortable with.

He also said the depth of the market, around €300bn, was much smaller than fixed income or equities and so the number of convertible bond managers was very small.

“What I do know is those that use them and have used them and are comfortable and understand the asset class are big fans and that same goes for companies that issue them,” he said.

Finding the right manager

Schrader noted that since being in the industry since 1994, he had not met a lot of convertible bond managers that could do the job well.
He said convertibles were very complex and had a long due diligence process and managers needed to know the bond market well, when to convert the bond, and the equity value.

“They also have to understand the triggers to convert and what it means when they don’t reach conversion. It’s a mixture to understand the bond and equity markets, and you have to have a really good lawyer to understand the contracts which are 100 to 300 pages long,” Schrader said.

He said that when looking for the right manager it depended on which performance and risk attribution he wanted to enrich in his allocation.

For debt defensive managers, Schrader said he looked for managers with more experience in the bond market who would be able to protect the portfolio on the downside for equity markets even if it meant a lower yield.

“For offensive managers they need to be able to figure out if the conversion triggers are worth the risk performance difference,” he said.

“The third type of manager I look for is one that cares about the triggers. These managers delve deeper into the contracts and convince me that they see mis-judgement from other analysts.

“They find mistakes in the contract such as triggers not being evaluated property and the value of convertibles and market prices are incorrect because they do not understand the conversion triggers.”

According to FE Analytics, three out of the top five performing convertible bond funds over the three years to 31 January 2019 were globally focused.

The Franklin Templeton Global Convertible Securities A accumulation fund was the top performing during this period at 30.2%.

The fund has its highest sector allocation towards information technology (32.5%), healthcare (14.7%), consumer discretionary (14.4%), communication services (9.5%), and materials (7.2%).

The highest geographic allocation was the US (63.8%), followed by Germany (9.1%), China (5.9%), Mexico (3.7%), and France (3.6%).

While these top funds performed well over the three years to 31 January 2019, the sector average was poor. In the FCA Recognised universe the sector average was 3.7% and 3% for the Offshore Mutual universe.

The top funds were found using FE Analytics that were domiciled in either Luxembourg or Ireland within the FCA Recognised universe or Offshore Mutual universe, were for sale in at least three continental European countries, and are rebased in euros.

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