The average credit quality and rating of convertible bonds has improved significantly in recent years. Thanks to their convexity, these hybrid instruments, whose universe is highly diversified, are more attractive than ever in any context. They are seen as halfway between investing in bonds and equities.
This is what Emmanuel Martin (pictured), manager of the Echiquier Convexity SRI Europe fund at La Financière de l’Echiquier (LFDE), said in an interview with Investment Officer.
According to Martin, convertible bonds can be a valuable addition to an asset allocation in all market conditions, as their hybrid nature, situated between bonds and equities, makes them much less volatile than shares, as a result of their convexity.
“Convertible bonds have the exceptional merit of being able to largely follow the rise of equity markets and cushion the fall,” he said. “In the long run, they capture two-thirds to three-quarters of the upside and only a quarter of the downside.” Martin added that “They are also less volatile than equities due to their convexity.”
According to Martin, convertible bonds have become even more attractive in 2021. First, many more issuers have issued convertible bonds in the past three years.
Secondly, last year was a record year in the US and in Europe the best year in the last six to seven years. As a result, the universe is constantly evolving and expanding, making more sectors investable.
“The credit quality of issuers has also improved significantly,” Martin added, describing it as a new and positive phenomenon. “We can now find some nice investment grade blue chips with a growth profile.”
Flows
The flow dynamics of the asset class have also improved. Convertible bonds have recently regained global interest.
According to the manager, inflows into these funds are increasing again. In 2021, there has been strong demand again, especially in Europe.
“The asset class has another merit, namely a short duration, which fluctuates around three years on average, thus limiting the impact of rising interest rates,” said Martin.
In the past, the duration was much longer, according to Martin.
Martin says 56 per cent of the European universe is rated. The average rating of these 56 per cent is BBB+, thus largely investment grade. In the unrated part, the remaining 44 per cent, LFDE’s managers use an internal rating, which on average corresponds to BBB.
The performance of convertible bonds in crisis years such as 2008 and 2011 was disappointing, said Martin, as credit spreads widened considerably.
“Hedge funds that had to sell were also heavily invested in them,” said Martin. “Now it is different, because in Europe 90 per cent of the universe is held by directional and institutional funds.”
Investment process
At LFDE, the investment process in convertible bonds takes place in four stages.
First, issuers that do not meet LFDE’s ESG requirements are excluded. The fund is one of the few convertible bond funds with the French government’s SRI label.
It applies sector exclusions, and an ESG rating of at least 5.5/10 according to LFDE’s own methodology is required to qualify for the fund.
Secondly, convertible bonds that are completely ‘out of the money’ or ‘in the money’, and therefore no longer offer convexity, are excluded. “We are not interested in bonds that have completely lost their equity sensitivity or, on the contrary, no longer have any credit sensitivity,” said Martin.
Thirdly, convertible bonds that are technically too expensive are also not investable. LFDE uses valuation models that determine the discount or premium to be applied to the theoretical value.
Fourthly, the managers focus on the upward potential of the underlying asset.
“It makes no sense to invest in an issue whose underlying value has little or no strong upward potential,” explained Martin. “For this, we rely on the expertise and know-how of the analysts and teams at LFDE who manage our equity funds (value, mid-cap, growth and others).”
As a result, the portfolio is concentrated around about 60 stocks.
“What also sets us apart from other convertible bond funds is that we use options to increase diversification and correct certain biases”, said Martin. “With options we will correct certain biases in the early stages, for example under- or over-represented sectors, or if there is too much emphasis on value or growth.”
The manager emphasises that these are options on companies, not indices, and are therefore not hedges. So they can buy options on AB Inbev if no brewer is included in the fund. “The underlying companies on which the options are bought must also be fundamentally attractive, with a credit quality that leads to low leverage,” he explained.
Sectors
The sector composition of the portfolio is highly diversified. Previously, there were more biases in the universe of convertible bonds, as seven or eight years ago the relative share of real estate, for example, was much higher.
Currently, there are no more pronounced sector biases in the fund, with balanced positions in sectors such as consumer discretionary, industrials, telecom, IT, real estate or healthcare.
Thus, there are not as many sector corrections to be made and, thanks to the individual corrections on individual securities with options, the natural biases can be reduced even further.
Martin nuances this by pointing out that the geographical spread is currently heavily biased. The portfolio is indeed heavily invested in French and, to a lesser extent, German securities, although the manager adds that this bias seems to be diminishing as the management of LFDE becomes increasingly international.
Average rating of the universe
About the Echiquier Convexity SRI Europe fund
Key figures
Absolute annual performance of the Echiquier Convexity SRI Europe fund at 30.04.2021:
- 1 year: +10.9%
- 3 years: +1.7%
- 5 years: +2.6%
- 10 years: +2.7%
- Since inception (12.10.2006): +3.0%