Convertible bonds in the eurozone: lack of fuel in the engine
Convertible bonds in the eurozone are highly correlated to the trend in the equity markets in today's economic environment. So we move from positive to neutral on this asset class to reflect our recent move to neutral on equities.
Convertible bonds in the eurozone have benefited from the strong rally in equity markets since the beginning of the year, appreciating by 2.8%. This follows a difficult 2018 when prices fell by 5.2%. Since adopting a positive stance on this asset class in January 2013, it has appreciated by 24.6%, representing an annualised increase of 3.7%.
It should be remembered that convertible bonds entitle the holder to convert them into shares at a date and under conditions that are agreed in advance. They therefore have the advantages of the share and the protection of the bond. There are numerous performance drivers, but some have run out of steam.
In the current environment in which bonds offer low yields and volatility is low, equity markets are the main driver of convertible bonds' performance. The correlation between the performances of these two asset classes exceeds 90%. As we have moved to neutral on equities, it makes sense to reflect this decision by moving to neutral on convertible bonds.
Credit spreads, the difference between the yield on bonds and the yield on the benchmark sovereign bond, widened significantly at the end of last year amid fears of an economic slowdown. Since then, they have narrowed partly thanks to the accommodative rhetoric from central bankers and the return of risk appetite. Credit spreads may narrow even further in the coming months as the latest macroeconomic data show that the economy is actually holding up better than the market had anticipated.
Coupons have been falling steadily for several years now, in line with the long decline in bond yields. This additional source of revenue enjoyed in the past no longer exits.
The rise in volatility is a positive factor for convertibles as it increases the value of the convertible bond's embedded option. That said, central banks have changed their tone, become more accommodative, and have pushed volatility down to levels below long-term averages.
Liquidity and covenants
Technical factors call for more caution. On the one hand, liquidity has dried up. On the other hand, covenants, or legal safeguard clauses in loan agreements which aim (among other) to force the company to comply with a number of financial ratios, have deteriorated for new issues and are now more advantageous to borrowers than lenders. Other weak factors in an environment where bond yields are expected to rise are the preference of issuers for long-term structures and the increased weight of certain sectors (utilities, real estate) in indices.
Convertibles remain attractive from a medium-term perspective as we remain positive on equities in the medium term. Their hybrid aspect between equities and bonds helps to increase the diversification and thus improve the risk/return ratio.