“If the fears of recession were to materialize, interest rates will likely decline. This will benefit convertibles, triggering an increase in value of the bonds and, other things being equal, an appreciation in the prices of low-delta names.”
Convertible bonds: what scenarios?
Thus begins the analysis by Nicolas CrémieuxHead of Convertible Bonds at Mirabaud AM explaining that “convertible valuations continue to be favorable and should benefit from a normalization of rates in the short to medium term, given the current lower volatility and mispricing of low-delta convertibles, which more often than not trade at lower prices higher than traditional bonds.”
Even new issues – explains Crémieux – represent an interesting opportunity. They are offered on the market at a discount compared to theirs theoretical fair value, by companies that are financially stronger and well-established (the current share of investment grade ratings across global issues is three times higher than the 10-year average), and therefore tend to have lower credit risk. Additionally, they generate income (average 2023 coupon is approximately 3%) and convexity (average 2023 delta is approximately 50%).
This is why they could be interesting again
2023 – it continues – was characterized by interesting M&A activities and we believe that these will remain important themes for 2024 too. We expect issuers of convertible bonds will continue to enjoy robust activity, as rising interest rates have not discouraged large companies from looking externally for growth. It is important to remember that holders of convertible bonds generally enjoy various protections from takeover risk, through a temporary downward adjustment of the conversion price or a possible early redemption at par.
Finally, given that the refinancing issue is increasingly important, we expect companies will increasingly look to convertibles as a financing channel that offers potential capital upside with lower coupons (between 300 and 600 bps depending on rating), potentially repurchasing outstanding convertibles at discount compared to the nominal value to optimize your balance sheets. Together with what was said above about new issues, this should support valuations, as these purchases are made at a premium to market prices.
As for the last few quarters “they have seen the mega-caps get the better of the rest of the market, to the point that since the beginning of the year over 75%(1) of the return of the S&P500 index has been driven by the so-called “Magnificent Seven”, namely Apple, Amazon, Alphabet, Nvidia, Meta, Microsoft and Tesla. The performance and valuation differential of large caps versus small caps, and indicators generally versus the companies underlying convertible bonds, have reached new highs. We believe that in 2024 this situation could reverse itself, even in the event of a recession, where large caps traditionally outperform due to the lengthening of the positioning, the expectations and multiples”.
“Things are changing”
Between 2022 and 2023 – continues Crémieux – “convertibles saw the greatest number of net outflows in history. But things are changing. With the recovery of issuance and the return of convexity, with increases greater than 1.17 compared to the decline of the underlying securities (year to date), and with the highest carry and downside protection in recent years, convertibles are now evaluated with metrics most interesting dat the time of the global financial crisis. We expect to see a positive inflection in flows as 2024 arrives.”