The final quarter of 2023 was quite a party for investors in both the bond and equity markets — but after the party comes the hangover.
As highlighted in the Q1 Bond Compass, in the 20 years preceding the end of 2023, there had only been four times when the monthly returns from the Bloomberg US Treasury Bond Index were at 3% or higher. Then there were two in succession, in November and December. The rapid decline in Treasury yields supported returns in equities and virtually all corners of the bond market. But after such extraordinary performance, some pull-back was almost inevitable in the early stages of 2024.
There has been a clear retreat from the heady market pricing of late 2023 while at the same time, confidence in a US soft landing has solidified. Activity data has been buoyant; the US Composite PMI edged up to 52.3 in January, pointing to growth — but not strong enough growth to swing the Federal Reserve (Fed) back into a hawkish state of mind. While there have been some slightly uncomfortable inflation readings, the narrative remains that this has been caused by one-off factors and that wider pressures are easing.
This environment has been more beneficial to equities than bonds. While the soft landing could allow central banks to cut rates, it is difficult to see the Fed delivering more than the 150 basis points (bps) of cuts already priced into money markets unless there is a material slowing in the economy. Meanwhile, the US earnings season is off to a positive start. Credit spreads have continued to compress, but convertible bonds offer a more direct way for bond investors to participate in potential upside from the soft landing.
The Refinitiv Qualified Global Convertibles Index returned 6.75% in Q4 20231, as the turn in the Fed rate cycle coincided with the year-end equity rally. Returns were also strong in 2019 and into early 2020 as the US rates cycle turned, so this seems to be a sweet spot in the cycle for convertibles: where the expectations of falling central bank rates intersect with a still active economy. While the start to 2024 may have been more challenging, there are several factors indicating that convertible bonds may continue to do well.
The SSGA Sector and Equity Compass highlights the potential for strong performance from US small- and mid-cap exposures as they play catch-up to the gains of large caps. The small/mid-cap profile of issuers in the Refinitiv Qualified Global Convertibles Index, which accounts for circa 35%-40% of the universe of bonds, is higher than most global equity indices. The profile of issuers in the index is also skewed towards technology (28.9%), which is a favoured sector given its quality and defensive attributes. Coupled with a heavy weight in communication services (15.1%), this should allow it to participate in the still-burgeoning AI theme.
After two months of solid gains, there are some questions on equity valuations. But for convertibles, these remain more balanced. The delta — or price sensitivity of the index to the underlying equity — for the Refinitiv Qualified Global Convertible Bond Index stands at 43.52. This is up from 35 as of end October, but remains a balanced profile. Historically, performance over the following 12-months has been positive, on average, when deltas have been in this range.
Figure 1: Delta of the Refinitiv Qualified Global Convertible Bond Index Remains Below Average
Lastly, the convexity profile offered by convertible bonds remains a viable equity alternative for investors who may be wary of the market’s path in 2024. The short duration, equity upside, and crossover credit characteristics may prove interesting for a risk-on backdrop. However, in a hard landing scenario, the relatively balanced profile and still low bond floor (ca 16% as of 29 December 2023) can act as protection for broad allocation portfolios.
There are some risks and opportunities from new issuance. The more favourable rates backdrop, coupled with the fact that a significant portion of pandemic-era deals are nearing maturity, means we are expecting to see issuance increase from circa USD $80B in 2023 to USD $90-100B in 2024. However, the run-rate has been contained so far this year, with issuance totaling USD $4.9B in 2024 year to date. New issuance can help liquidity in portfolios and, in some cases, interesting participation to growth for bond investors.