Want to share some takeaways I had after reading Jefferies’ Feb 7 2019 report on convertible bonds (Sean Darby, ‘Global Asset Allocation: An Equity Investor’s Guide to Convertible Bonds’).

• CB issuance, turnover and liquidity are better than investors perceive
  • Breaking down for market cap
    • by region, among the 314bn issuance outstanding, US accounts for 55% (172 bn), Europe 28% (87 bn), Japan 8% (25.9 bn), Asia Ex 9% (28.8 bn).
    • by sector, IT 18%, Health Care 11%, Con Discretionary 11%, Industrial 10%, Real Estate 9%, Con Service 9%, Energy 8%, Materials 8%, Financials 7%, Utilities 5%, Con Staples 2%.
    • by profile, 37% bond-like (<30D), 41% balanced (30-70D) and equity-like (>70D) 22%. US CBs are more equity-like than European CBs, which are more debt-like in nature.
    • by credit, IG (<200 bps) 59% and HY (>200 bps) 41%.
  • Liquidity is not a constraining factor in the US. The CB market annual volume over market size is 1.9X vs 1.4X in the US HY credit market.
    • US CB volume traded annually= $325bn, market size= $172bn, turnover=1.9X
    • US HY volume traded annually=$1.74tn, market size=$1.22tn, turnover=1.4X
  • Issuance of CB has increased significantly over the past 18 months as corporate issuers attempt to raise capital ahead of rising interest rates.
    • The CB asset class has traditionally boomed in such periods as it gets more expensive for these issuers to issue in the HY market with rising rates. The US issuance has high correlation with US rates. We are likely to see substantial issuance in the coming years, as the rate cycle in both Europe and Asia catches up with the recent US rate hikes.
    • As interest rates begin to rise (Fed continues the normalization policy), the CB issuance is expected to increase as can be seen from historical evidence.
• Why do companies issue CBs?
  • They are less expansive to raise capital than straightforward equity or bond.
  • Compared with bonds, investors require less coupon in CB.
  • Compared with equities, its ability to deduct interest payments from tax obligations helps lower the cost of capital.
• The benefits of CBs as an asset allocation tool
  • Convexity- price will tend to fall at a slower rate than underlying equities. CBs offer the potential for more upside than losses on the downside or asymmetric price behavior.
  • Since 2009, CBs has performed in-line with global equities. During equity sell-offs, CBs have protected investors, while providing up-side participation.
  • CBs have tended to outperform other fixed-income asset classes in periods of rising interests (rates tightening cycles). While HY bonds have a tight correlation to equities, they do not offer the same downside protection. Why CBs provide protection during rates hike periods?
    • Firstly, as equities represent a participation in the real economy they generally appreciate in nominal terms as rates rise. This exposure to rising equity prices mitigate the shortcomings in duration.
    • Secondly, CBs tend to have shorter duration than straight bonds. Over the past 20 years, any time US treasury yields have risen by over 100 bps, CBs have tracked equities better than bonds.

The bottom line: CBs offer equity ‘optionality’ with low volatility alongside reduced drawdown. CBs’ asymmetric structure combines the best of equties and bonds, making them a perfect diversification tool as Central Banks normalize policy.