Rise of interest rates, time for convertible bond

Nicolas Delrue -

Certain market environments give convertible bond investors even better deals than others.

Traditionally known as “all-weather” assets thanks to their dual nature, a bond instrument, providing the downside protection, with an embedded call option, allowing for equity upside potential. In today’s macro context, we believe conditions are ripe for convertible bonds to stand out.

With the rise in interest rates well underway in the US and with still ultra-low yields and ultra-tight spreads in European credit markets, both investors and issuers are looking at convertible bonds with fresh eyes.

From an investor’s standpoint, the option in the convertible bond – positively correlated to changes in interest rates – enables to partially offset the loss on the bond side in rising-rate markets. History has shown that periods of rising interest rates were paired with positive equity momentum and thus turned particularly supportive for convertible bonds. This appears all the more valuable at a time where, in contrast, yields offered in the fixed income space remain too low to compensate for the induced capital loss. Looking forward, we believe sound economic expansion should boost company earnings further, hence providing convertible bonds with additional driving force.

Such markets also support convertible issuance dynamics. With interest rates on the rise, the lower coupons traditionally offered in the convertible bond space – in exchange for the conversion right – constitutes a key argument in favor of the asset class for companies with financing needs. Figures speak for themselves. At June-end, yearly new convertible issuance amounts to USD 42.3bn – USD 4bn ahead of the volume recorded over the same period last year. In the US, Tech companies in particular have been very active, reflecting improving global growth. With still 3 FOMC meetings to come by year-end, investors taking a closer look at the ECB’s minutes in search of a clue as to its next move, and given equity markets’ strong performance, we expect this trend to continue going forward. For bottom-up investors, this is the prospect of greater diversification opportunities, at a time where valuations remain attractive in the convertible bond space.

Nicolas Delrue – Head of Investment Specialists and Senior Investment Specialist Convertible Bonds – Union Bancaire Privée (UBP)