Aggressive pricing hurts convertible bond market
Convertible bonds are hybrid financial instruments that combine debt and equity-like features. They resemble conventional bonds in that they pay a defined coupon and principal upon maturity, but they also possess an embedded option giving holders the right to convert the bond into a set number of shares. The conversion option thereby allows convertible bonds to be naturally convex (meaning they should diverge to the positive from benchmarks during extreme markets).
Historically, this natural convexity has ensured returns for convertible bonds comparable to those for equities. They participate in equity bull markets while they offer protection during equity sell-offs. Convertible bonds have generally demonstrated structurally lower volatility than their underlying equities, meaning the value of the conversion option increases during volatile markets. Global issuance has only gained traction in the past 20 years, but the asset class remains small, with a market capitalisation of just over USD 0.5 tr, accounting for 0.3% of total global financial assets under management.
Strong performance and a favourable market environment attracted a wave of opportunistic convertible issuance in 2020 and 2021. The underperformance of convertible bonds this year can largely be attributed to these new deals. Deal pricing had climbed to very aggressive levels, with coupons far below average and substantial average conversion premiums, which weakened the “bond floor”. This is the theoretical investment value of an issuer’s bond without the conversion feature, below which the value of the convertible bond should not fall. In the event, this year’s rise in market rates and in corporate bond yields has undermined the bond floor of the most aggressive convertible bond issues, which have thus offered lower downside protection to investors.
While the rise in US Treasury yields has hurt their bond floor, convertible bonds have also been exposed to increasing equity volatility. On average, convertible bonds showed around 60% of the volatility of blue-chip US equities between 1999 and 2019. This limited the downside risk for convertible bonds. However, more recently, the persistence of high volatility has rubbed off on the convertible bond market, whose volatility has risen to about 90% of US equities’. Overall, around 15% of the global convertible chart market now trades in the “distressed” category, with prices near or below their theoretical bond floor.
Historically, distressed convertibles, offering a comparatively high yield, have outperformed during market rebounds. But despite the rise in yields for convertible bonds this year, they look far less appealing than the yields offered by investment grade and high-yield bonds in light of comparatively high default and credit risk. The silver lining is that while economic growth is set to soften this year, we could see less aggressive pricing by growth companies once conditions look like improving again. Therefore, while it would be premature to buy convertible bonds now, opportunities will re-emerge.