Is now the time for convertible bonds?

On March 15th, the Fed came out with a second interest rate hike in three months and reiterated that further increases should be expected this year.

While this is more an imminent issue for US investors, European credit markets are not immune. Last December’s hike gave strong evidence of how the European yield curve can be affected by cross-Atlantic decisions. For investors looking for alternatives to their bond investments, this constitutes a strong call in favor of convertibles.

When faced with an interest rate rise, convertibles’ embedded option acts as a safety cushion which partly offsets the negative impact on the bond component. History has shown that rising interest rates were often paired with bull equity markets; over the past 15 years, during each period where the Bund 10Y’s yield increased by more than 120bps, the gain on the convertible’s option more than compensated for the loss on the curve. Such feature is all the more valuable in an ultra-low rate environment, where one cannot count on the carry to offset the detracting impact on the credit of an interest rate hike.

Besides, the ECB’s extensive asset purchase program has induced a strong distortion in the straight bond market, draining the opportunities in terms of spreads and maintaining downward pressure on yields. Comparatively, convertibles have remained preserved from this massive distortion effect, which allows them today to offer much higher value potential than corporate bonds, at comparable duration levels.

The impacts of such market distortion are also clear at security level. In current ultra-low rate environment where corporate bonds are being “overbought”, some convertibles have started to display higher yields than their equivalent straight bonds. For the investor, this means the opportunity to benefit from an exposure to the underlying stock upside potential for free relative to the straight bond –a valuable alternative to ultra-low yields, at a time where equity markets are supported by higher growth expectations and policy tailwinds.

Nicolas Delrue – Head Investment Specialists – Union Bancaire Privée (UBP)