Fisch Asset Management AG,
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Executive Summary
- In times of rising interest rates, convertible bonds perform robustly and fare much better than a composite portfolio comprising equities and traditional bonds.
- Similarly, in inflationary periods, historical comparisons show that convertible bond performance is positive on average, but very mixed when it comes to analysis of individual timeframes.
- Therefore, active management is essential for managing interest rate and inflation risk.
- Active managers like us determine not only sector allocation but also individual security selection, based on an array of factors, in order to bolster the advantages of convertible bonds in an environment such as the one prevailing.
Investors with sizeable bond allocations in their portfolios have for some time been faced with an inevitable fact: interest rates are rising, resulting in losses on their bond positions. This trend is likely to continue because interest rates could climb further in the coming months due to economic improvement or rising inflation. Sovereign and corporate bonds (especially those of higher quality) come under pressure as interest rates rise, whereas equities historically do well in times like these. So, how would a security with both equity and bond-like properties behave in this environment? This is where the convertible bond comes in.
A comparison of convertible bonds with other asset classes
As one would expect, the fixed-income component of a convertible bond reacts negatively to rising interest rates. However, the equity component balances out this effect: Firstly, the value of the call option on the underlying equity increases as interest rates rise; secondly, it benefits from the rising share price (which tends to be the case in inflationary market phases). So, cumulatively, the negative effects are cushioned by the positive. Thus, interest rate sensitivity is significantly determined by equity exposure via the call option of the convertible bond in addition to the duration of the fixed-income component. Essentially, the lower the duration and the greater the equity exposure of a convertible bond, the lower the interest rate sensitivity.
In general, convertible bonds have a relatively short effective duration. As measured by the Refinitiv Global Vanilla Index, this is less than two years. This figure is based on the short maturity of around five years that is typical of convertible bonds and the right to convert the bond into the underlying equity (by virtue of the call option), which is taken into account when calculating the effective duration, thus shortening it. In a direct comparison with a traditional corporate bond with the same maturity, a convertible bond therefore has a (generally much) lower duration.
Performance of convertible bonds in a rising interest rate environment
Historical comparisons with corporate bonds (Bloomberg Barclays Global Aggregate Corporate USD hedged Index) and equities (MSCI World Index USD hedged) demonstrate that convertible bonds can come into their own in a rising interest rate environment (Fig. 1).
Fig. 1: Performance of CBs vs other asset classes in periods of rising interest rates
Source Fisch Asset Management, Refinitiv Global Vanilla Hedged CB Index (USD), Bloomberg Global Aggregate Corporate Hedged (USD), January 2022
Convertible bonds beat corporate bonds in all 10 periods of rising interest rates (>100 basis-point increase in the 10-year US Treasury yield). In one of the 10 periods (Dec. 2008 to June 2009), convertible bonds even outperformed equities. When we compare the average returns for the three asset classes in these 10 periods (Fig. 2), we see that convertible bond performance (+9.7%) reflects equity returns (+11.5%) rather than bond returns (-1.4%).
Fig. 2: Average CB performance in a rising interest rate environment: just behind equities and well ahead of corporate bonds
Source: Fisch Asset Management, Refinitiv Global Vanilla Hedged CB Index (USD), Bloomberg Global Aggregate Corporate Hedged (USD), January 2022
The strong performance of convertible bonds in periods of rising interest rates cannot simply be replicated by a combination of equities and bonds. To illustrate this (Fig. 3), the analysis was redone with a composite portfolio (consisting of a mix of 50% MSCI World and 50% Bloomberg Barclays Global Aggregate Corporate Index, rebalanced monthly).
Fig. 3: CBs well ahead of composite portfolio of equities and bonds in periods of rising interest rates
Source Fisch Asset Management, Refinitiv Global Vanilla Hedged CB Index (USD), Bloomberg Global Aggregate Corporate Hedged (USD), January 2022
The analysis clearly shows that convertible bonds beat the 50:50 equities/bonds allocation in all 10 periods of rising interest rates. Average returns in these periods were also striking: convertible bonds returned +9.7% versus +4.9% for the composite portfolio. The reason for this is the call option embedded within convertible bonds, which increases in value in a rising interest rate environment. This mechanism cannot be replicated purely by combining equities and bonds.
Convertible bonds in an inflationary environment
Of course, rising interest rates also drive up inflation expectations. We must therefore ask ourselves whether convertible bonds remain attractive in an inflationary scenario. To answer this question, we compared the performance of convertible bonds with equities, corporate bonds and a composite portfolio (50% MSCI World + 50% Bloomberg Barclays Global Aggregate Corporate, rebalanced monthly) in various inflation scenarios. This comparison was based on data from 1991 to 2021. During this timeframe, there were 10 periods (see Fig. 4) of rising inflation (defined as >1% yoy change in the US Consumer Price Index (CPI)).
Fig. 4: Performance of convertible bonds vs other asset classes in periods of rising inflation
Source Fisch Asset Management, Refinitiv Global Vanilla Hedged CB Index (USD), Bloomberg Global Aggregate Corporate Hedged (USD), January 2022
This again confirms the picture that we drew previously from periods of rising interest rates. Convertible bonds fare very well in such an environment, and can also markedly outperform a composite portfolio of equities and corporate bonds. As you would expect, equities perform particularly well in these scenarios. The reason for this is that higher inflation is associated with positive economic growth, higher company earnings and corresponding share price rises.
Fig. 5: Average performance of various asset classes in periods of rising inflation
Source Fisch Asset Management, Refinitiv Global Vanilla Hedged CB Index (USD), Bloomberg Global Aggregate Corporate Hedged (USD), January 2022
However, on closer analysis of the 10 periods of inflation identified, we see clearly that the performance of the asset classes, including convertible bonds and equities, varied widely. Although both equity and convertible bond performance (see Fig. 5 above) was positive on average, performance in individual periods was patchier. In fact, equity performance was negative in four out of the 10 periods. This was also true of convertible bonds, albeit with lower losses. In these periods, rising input costs probably had a distinctly negative effect on company earnings.
The analysis thus essentially paints a positive picture for equities and for convertible bonds in an inflationary environment. However, this cannot be said for all periods. Another important factor, we believe, is equity market valuation. To illustrate this, we analysed the effect of inflation (as measured by the annual US CPI) on the price/earnings ratio (PE, y-axis) in the equity market (in this case the S&P 500 index) in the following chart.
Fig. 6: Link between equity valuation and inflation rate
Quelle Fisch Asset Management, Bloomberg, S&P 500, as of 31 January 2022
The results are clear: the higher the rate of inflation, the lower the PEs that investors are prepared to pay. Also, with higher inflation, a higher discount factor applies to future earnings. Another interesting observation on the above scatter diagram is that the effect of inflation on PEs is less significant at lower rates of inflation (<5%). Here, it is obvious that other factors (such as sector, and company pricing power) play a more significant role for the valuation. We take this on board in our active selection in addition to the current valuation of overall equity markets.
Active management of interest rate and inflation risk
In addition to the pre-existing advantages of the convertible asset class, we actively manage the interest rate risk through sector and security selection of the underlying equities. In the current rising interest rate environment, we avoid convertible bonds from interest-rate-sensitive sectors, such as telecommunications and real estate. At the same time, we prefer investing in convertible bonds from sectors that should benefit from rising interest rates, such as banks and insurance companies. Thus, with targeted positioning in relation to interest-rate-sensitive sectors and companies, the portfolios offer added protection against interest rate risk.
Selecting those that stand to benefit from, and avoiding those vulnerable to, changes in interest rates is far more complex than a simple matter of sector analysis. In the current environment, equity valuations in particular are hugely important. Expensive growth stocks exhibit very high valuations by virtue of their long-term growth potential. However, expected earnings are far off in the future. Such stocks in particular often react very negatively to rising interest rates, as future company earnings consequently have to be discounted at a higher rate. The movement in prices in January 2022 alone clearly showed how sensitive very high-priced stocks can be. The following scatter diagram plots the performance (y-axis) of the equities underlying the convertible bonds in January and the respective price/earnings ratio (PE, x-axis) of the share. The higher the PE, the higher the valuation or the more expensive the share. The regression line illustrates that companies with higher valuations tend to show a poorer performance.
Fig. 7: Equities with high valuations came under stronger pressure in January 2022
Source Fisch Asset Management, Bloomberg, as of 31 January 2022
However, the convertible bond universes (indices) are represented to varying degrees in these expensive stocks. The following analysis looks at the universe from the point of view of the EV/best sales ratio. This metric expresses the current enterprise value (EV) in relation to analysts’ estimates for future sales over the next 12 months. Here too, a higher ratio means a more expensive valuation. The following table shows the corresponding distribution of equity exposure (delta) of the various indices:
Table 1: Expensive companies are distributed very unevenly across the different CB indices
Source Fisch Asset Management, Bloomberg, Refinitiv, as of 31 January 2022
The analysis confirms that the universes with a high yield component (Refinitiv Global Focus and Refinitiv Global Vanilla index) are exposed to expensive stocks to a greater extent. The investment grade universes, on the other hand, are exposed to these expensive segments to a much lesser extent. This can be explained by the fact that many growth companies have a high yield rating and so are not represented in the investment grade indices.
We also take this on board in our active portfolio management by avoiding expensive growth stocks and concentrating more on growth at a reasonable price (GAARP). The positioning of our Opportunistic strategy is a good example of this. As of 31 January 2022, the portfolio was underweight high-priced (>10 EV/sales) stocks by 4%, and overweight cheaper segments of the market.
Table 2: Application of the GAARP approach in the Opportunistic strategy
Source Fisch Asset Management, Bloomberg, Refinitiv, as of 31 January 2022; key: MV=Market Value; Port w=Portfolio weight; Bench w=Benchmark weight; Active w=Active weight; EE=equity exposure
In addition to managing the interest rate risk, we also manage inflation risk within the portfolio through active sector allocation. As the figure below shows, sectors react differently to higher inflation. Defensive sectors, such as telecommunications and consumer staples, but also healthcare, fare worse in relative terms. We take this on board in the allocation process, favouring sectors that tend to do better in an inflationary environment, such as materials, energy and technology.
Fig. 8: Sectoral performance of the US equity market in periods of rising consumer prices
Source Fisch Asset Management, S&P sector indices from 1991 to end of December 2021, January 2022
However, not only do we actively select the sectors; when managing the inflation risk we also take on board the fact (see Fig. 6) that, in an environment of low inflation (<5%), factors other than the higher discount factor play a much more significant role in assessing share prices when it comes to security selection. For example, we focus very consciously on companies with pricing power. We also pay close attention to wage costs and avoid companies in very labour-intensive sectors and those with low margins.
Conclusion
Convertible bonds have clearly demonstrated their advantages as a hybrid security in periods of rising interest rates, not only when compared directly with other asset classes but also in comparison with a 50:50 composite portfolio. In addition, by focusing on beneficiaries of rising interest rates and positioning themselves in sectors and companies with pricing power, active portfolio managers have the opportunity to generate additional returns on rises in interest rates and inflation.