The Covid-19 virus outbreak and its implications have caused considerable disruption to the market. In this challenging environment, convertible bonds have been able to deliver on their promise and offer investors a degree of protection relative to the global equity market: while the MSCI world index of all countries in euros fell about 11% since the beginning of the year (data as of May 13, 2020), convertible bonds, according to the Thomson . Convertibles Global Focus index in euros, they gained 1.6% during the same period. This is due to asymmetric risk / return profile of convertible bonds: When stock markets rise, convertible bonds are largely up, but when prices drop sharply, the sensitivity of convertible bonds decreases and they become more bond-like. “Our pThe outlook for the rest of the year is positive. However, if volatility increases, the “hedging” component of convertible bonds will come in handy, ”says Brillois.
In addition to downside market protection, convertible bonds offer interesting prospects, according to Brillois. Convertible bonds are currently undervalued in the secondary market in terms of implied volatility. “In March, implicit volatility (with a simultaneous high level of realized volatility) reached a level not seen in 10 years,” says Brillois. The manager expects convertible bond valuations to fully recover within three to five years. “If these expectations are met, the most patient investors could be rewarded with high profits for investing in convertible bonds,” says the expert.
Active primary market
The reopening of the primary market could also create interesting investment opportunities. “The primary market is currently quite active with several new problems and we expect issuance activity to remain high, “says Brillois.” Especially companies in sectors affected by the recession that are likely to use convertible bonds as their primary financing instrumentFor two reasons: On the one hand, coupon payments on convertible bonds are relatively low, making the issue attractive in times of widening credit spreads. On the other hand, convertible bonds have an option of buy-in. “If the volatility of the underlying stocks increases, the built-in option also increases the valuation of convertible bonds,” Brillois explains. “Therefore, issuers receive a higher price, an additional incentive for companies to issue convertible bonds. “
further, the liquidity of convertible bonds is very good compared to other asset classes, such as high yield. “The average supply and demand spread for convertibles is typically around 70 basis points. In March, during panic sales in the markets, this figure increased to 160 basis points, but has now practically returned to pre-Crown levels ” Brillois says. For comparison, Moody’s 5y Baa corporate bond index, for example, showed a supply and demand differential of around 340 basis points.
Brillois summarizes: “Current market distortions make a convertible recovery strategy attractive to investors, that is, investing in convertible bonds issued by companies that have significant recovery potential. Investors can benefit from the devaluation of such convertible bonds and their potential for recovery. “
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