Talking Heads – The case for long-short convertibles in volatile times

This is an edited audio transcript of the Talking Heads episode with Skander Chabbi

Daniel Morris: Hello and welcome to the BNP Paribas Asset Management Talking Heads podcast. Every week, Talking Heads will bring you in-depth insights and analysis on the topics that really matter to investors. In this episode, we’ll be discussing convertible bonds. I’m Daniel Morris, Chief Market Strategist, and I’m joined today by Skander Chabbi, Head of Convertibles. Welcome, Skander, and thanks for joining me.

Skander Chabbi: Hi, good to be here.

DM: We want to talk about convertible bonds and the market environment, the macro environment.  One of the potential surprises we’ve had over the last few months is arguably higher volatility in equities. Before the US election, it was supposed to be soft landing, which was a benign environment. That was going to be premised on declining inflation. We have more inflation worries, leading to higher policy rates or at least higher market rates. Can you share with us some of the recent developments in the market?

SC: First, as we’ve seen rates move back into positive territory over the past two or three years, it’s been a much more favourable environment for convertible bonds because these instruments that tend to capture both the performance of credit markets and equity markets were suffering from a lack of competitiveness. With expectations that rates would remain higher, the convertible bond market becomes a good option for a lot of issuers to refinance some of the debt because they are able to achieve substantial savings in terms of coupon payments by employing convertible bonds.

In terms of higher volatility and raised uncertainty,  the convertible bond product tends to be a favourable instrument because the returns tend to be asymmetric, which means they capture more upside than downside. The market tends to provide a better risk-adjusted return over time, particularly when you compare it to the performance of equity markets.

Recent changes have been positive. We’ve seen some beginning of issuance in the renewables sector and in the green bond format. And we also saw a resurgence in issuance out of the technology space. It’s been quite active. We’ve seen small [and] midcap companies use the convertible bond market as a source of refinancing, giving us the opportunity to get exposure to companies which you don’t typically find across other [bond] markets such as credit or high-yield. Many of these companies are subject to takeovers and going forward, they tend to be bought out by larger companies. So, you don’t only depend on the potential performance of equity, but you can depend also on the good performance of the company and therefore the probability that this company gets taken over.

And finally, the crypto currency market has provided a big source of new issuance. We’ve seen a lot of companies in this sector use the market as a source of financing to purchase cryptocurrencies. Although we’re not necessarily very involved in this market, it has provided for a lot of new issuance and has seen a significant impact on the performance of the asset class last year.

DM: You highlighted higher volatility. What does that tell you about performance expectations for the asset class and can you also talk about how you see convertibles in the context of a traditional portfolio?

SC: We’re always looking at performance expectations relative to other asset classes. So, we set ourselves different scenarios. The idea is for a, let’s say, up 10% equity market overall, how much are we going to be able to capture of this performance? Typically, the ratio that we’re looking at is plus 7% for a 10% return of equity markets. And if the equity market is down 10 {%}, you’re looking to catch about 4% of that downside. That can be appealing for typical equity portfolio managers.
This is where we tend to see most of the investor interest in these uncertain times.

If you’re able to diversify your equity allocation and add an allocation that provides you with a better risk-adjusted return you’re bringing down the volatility of your allocation by adding a slice of convertibles. What we typically see is that large institutional investors tend to have somewhere between 4% and 8% of [the] allocation to convertible bonds in their overall portfolio,  gaining exposure to a range of names which you don’t typically find in either the credit markets or the equity portfolios of mainstream funds.

DM: Most investors are used to thinking about long-only investments, long-only asset classes or funds. With convertibles, you can also look at long/short strategies. Could you talk about how you view those options in the current environment?

SC: That’s equally an opportunity for investors. Overall, it gives a market-neutral exposure because in a nutshell, you’re long an asset, which is the convertible bond, and you’re short of the underlying equity. Therefore, you are adjusting your position as the stock moves day over day. This kind of strategy has provided a stable return. The higher volatility regimes provide usually for more sources of value or more investment opportunities, being able to pick what we call cheap convertibles. These strategies have been popular over the past four years now and they’ve come to nearly dominate the convertible bond investor base.

So, it’s interesting for investors that are looking for a different kind of exposure with less risk and less volatility.

DM: If I could summarise some of the key points that you shared with us, how the higher rates environment that we have today [is} more positive for convertible bonds also with higher equity market volatility. You also talked about how the returns for convertible bond portfolios ideally are asymmetric meaning that you capture more of the upside than the downside. And finally, when you think about asset allocation, convertibles can help reduce volatility and improve diversification. Well, Skander, thank you very much for joining me.

SC: Thank you for your time.

DM: That’s it for this week’s episode of Talking Heads. If you would like more information about our capabilities in convertibles, please reach out to your BNP Paribas Asset Management contact or check out Viewpoint, our website for investment insights at viewpoint.bnpparibasam.com. Viewpoint brings commentary and analysis in a variety of formats, from investment outlooks to asset allocation videos and podcasts to help investors make better informed decisions. You’ve been listening to the BNP Paribas Asset Management Talking Heads podcast with me, Daniel Morris, and Skander Chabbi, Head of Convertibles. Please do join me next week. Until then, take care.