After the ECB offered more support for the EA on 4 June, extending asset purchases and lifting risk appetite, the US Federal Reserve had its turn last week. As expected, the FOMC reiterated its strong support for the economy in the post-pandemic recovery. The Fed also signalled asset purchases would continue “at least” at the current pace and insisted they would keep rates near zero until 2023.
That commitment is consistent with new economic projections reflecting a slow and incomplete recovery. While the Fed expects a relatively dynamic recovery in the second half of 2020, the projections beyond that point remain conservative, with the unemployment rate still well above pre-crisis levels.
Despite the Fed's strong commitment, risk appetite consolidated further on Wednesday and Thursday last week. Equity prices fell by more than 6% over two days, and US Treasury 10Y clawed back to below 0.7%. Meanwhile, the USD stabilised after a long downtrend.
Much has been noted about rotation and reflation in the past few weeks. The market reaction we saw last week supports the view that, if central banks can support risky asset prices by reducing the risk-free rate and capping risk premia, there may be a limit to how much they can propel prices higher while economic prospects remain weak and uncertain. We also remain wary of a second virus wave in the US and further increases in COVID-19 cases in Latin America, which could dash hopes created by the easing of lockdowns in Europe and Asia.
So the key question for investors is, Where to invest in a market characterised by an high velocity and liquidity? In our view, global convertible bonds appear well suited to navigate the current uncertain and potentially more volatile markets.
What have convertible bonds done so far and what profile do they offer the investor who wants to stay invested?
Global convertible bonds exhibit an interesting balance between growth and protection thanks to their hybrid nature. With more than $60 billion in new issues year to date1, the companies tapping the market range from faster-growing tech and health care companies to cash-strapped retailers offering potential upside value as they turn to the market with concessions that investors have seized.
Since the beginning of the year, and during of the ensuing turmoil, global convertible bonds have played their role in protecting versus the downside of equity exposures. Moreover, thanks to a lower exposure to energy, convertible bonds have outperformed high yield corporate bonds, notably US high yield. Since the market trough, new issuance has been strong and the specific profile of the global convertible bond universe has been a beneficiary of the catch-up in riskier assets (see Figure 1).
Figure 1: YTD Cumulative Performance (in USD unhedged)
Source: State Street Global Advisors, Bloomberg Finance L.P., as of 12 June 2020. Past performance is not a reliable indicator of future performance. It is not possible to invest directly in an index. Index performance does not reflect charges and expenses associated with the fund or brokerage commissions associated with buying and selling a fund. Index performance is not meant to represent that of any particular fund.
There are regional differences, with the larger US exposures providing growth and higher equity-like opportunities, while Europe and Japan can offer quality and defensiveness. The relative cheapness of Asia helps to provide investors with convexity and diversification, as volatility has receded to below 30s while deltas have hit higher levels (see Figure 2).
Convertible bonds can also offer a balance between large, mid and small cap names, which stand to benefit from the various sequences of equity recoveries. In terms of sectors, the skew towards health care and technology is welcomed, as they remain more protected in the recovery post COVID-19. Last, the convexity of the exposure is a helpful drawdown dampener in a still uncertain world.
Figure 2: Refinitiv Qualified Global Convertible Bond Index – delta evolution
Source: State Street Global Advisors; Bloomberg Finance L.P., as of 10 June 2020.
The three engines of convertible bonds (rates via coupons, equity and volatility) have been re-ignited. Investors could consider this an ‘auto-allocation’ tool while we wait for further improvement and scrutinise leading indicators for confirmation that we are on the long road to recovery.
For investors hoping to investigate this topic further, we invite you to read our recent note,
Sources: Bloomberg Finance L.P., for the period 5-13 June 2020. Flows are as of date indicated and should not be relied upon as current thereafter.
1 Source: BofA Merrill Lynch, as of 11 June 2020.
2 Prior to 29 May 2020, the Fund was known as SPDR Thomson Reuters Global Convertible Bond UCITS ETF (Dist).
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