With numerous crosscurrents for investors to contend with, the Polar Capital Global Convertible team believe market volatility is likely to remain elevated over the medium term. In this environment, convertible bonds, due to their unique attributes, should outperform equity markets.
Convertible bonds have historically benefitted from rising market volatility
As a reminder, a typical convertible bond can be thought of as a straight bond plus a long-dated equity call option. This means that as the value of the underlying equity rises, so too does the value of the call option, resulting in potentially unlimited upside. On the other hand, as the underlying equity falls and the option component decreases in value, the value of the convertible as a whole is protected to the downside by the present value of the remaining coupon stream and principal that is received upon maturity – that is, the value of the straight bond component. This combination of unlimited upside potential and capped downside ensures that convertible bonds provide a highly asymmetric means of seeking capital returns with mitigated drawdown risk.
Convertibles’ combination of unlimited upside potential and capped downside ensures that they provide a highly asymmetric means of seeking capital returns with mitigated drawdown risk
As with a typical call option, the fair value of a convertible’s embedded call option – and, therefore, the fair value of the convertible bond as a whole – increases as the volatility of the underlying equity increases. We believe this positive correlation to volatility is a substantial driver of convertibles’ outperformance over equities during times of market dislocation.
Indeed, as shown in the chart below, this has historically been the case. Specifically, as the volatility of the underlying equity market increases, convertible bonds tend to outperform equities.
The rolling one year performance differential of Global Convertible Bonds over stocks has tracked the realised equity volatility over the last 20 years
Source: Bloomberg & BAML. (Convertible Index: VG00), 29 February 2020.
Are convertibles outperforming during the current period of elevated volatility?
The simple answer is ‘Yes’. As the chart above shows, convertible bonds tend to outperform equities during times of increased uncertainty. With markets exhibiting elevated volatility at the beginning of 2020, this pattern appears to be repeating. In particular, as shown below, at the time of writing global convertibles have substantially outperformed global equities year to date, protecting 75.9% of capital as they have participated in only 24.1% of the market drawdown:
Source: BofA ML Global Convertible Index*; MSCI World Index**; in dollar terms, 10 March 2020.
We believe equity market volatility may remain elevated over the medium term
Investors today are contending with numerous competing crosscurrents. These include:
- The health and economic implications from the developing COVID-19 pandemic
- Recent oil price shock
- A prolonged trade and technology war between the US and China, with the very real possibility of an escalation of US/European trade tensions over the medium term
- Greater nationalism and populist politics alongside a gradual unwinding of globalization
- Upcoming US presidential election
- Ever-present geopolitical tensions, from Iran to North Korea
- Late-cycle dynamics of developed world economies following the longest period of economic expansion on record
- The possible inability of major central banks to stimulate economic growth with interest rates at or near record lows
In this context, we believe equity market volatility may remain elevated for some time.
The approach of the Polar Capital Global Convertible team
Since inception of the Fund in 2013, the Polar Capital Global Convertible team has maintained a consistent and robust approach to portfolio construction. The most important aspect of this approach is to ensure that downside protection is present when it is most needed – during an equity market selloff. We aim to achieve this by careful analysis of both the credit strength of each individual investment within the Fund as well as of the Fund as a whole. Indeed, at the time of writing, the portfolio had an aggregate credit quality of BBB-, no investment in the Fund has suffered material credit deteriorations and the team has a long track record of avoiding severe negative credit events including Abengoa, Carillion, Folli Follie, Intelsat, Intu Properties, Nio, NMC Health, Nyrstar, Sino Forest and Tullow Oil, to name a few.
In addition to our emphasis on downside protection, the team also focuses heavily on investing in convertibles with particularly high asymmetry of returns. Together with a strong credit backstop, this characteristic amplifies the mitigation of drawdown risk and preservation of upside participation. This process has worked particularly well both in the recent period of rising volatility and since inception of the Fund. Indeed, at the time of writing, the Fund has participated in only 17% of the year-to-date equity market drawdown (I Acc USD share class, as at 9 March 2020) while this approach has enabled the Fund to outperform its benchmark by 1,118bp since Fund inception (164bp annualised).
Given our outlook that market volatility may remain elevated going forward, we believe convertibles will continue to enjoy strong relative and risk-adjusted returns over the short and medium term.