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The first quarter of 2022 proved to be challenging for most fixed income sectors, and convertible bonds were not immune from the volatility. Year to date through March 31, global convertibles had returned -5.81% — their third-worst quarterly showing since the 2008 global financial crisis — compared to -5.54% for global high-yield bonds and -6.90% for global investment-grade corporates.1 Sector composition particularly hurt global convertibles, including a sharp correction across technology (which makes up 23.8% of the convertibles universe) in response to concerns about the potential impact of higher interest rates on tech companies’ growth prospects; and a rally in the energy sector (4.0% of the convertibles universe), fueled in part by supply disruptions from the war in Ukraine.
Looking ahead, however, we continue to believe global convertibles are likely to outperform other fixed income sectors over an investment time horizon of approximately two to three years.
The five structural tailwinds
Our bullish secular outlook for global convertibles is based on five key considerations
- Positive forward-looking total-return potential due to:
- What we see as reasonable to somewhat attractive credit valuations vis à vis the equity market (Figure 1);
- Positive convexity2 in a negatively convex, lower-yielding high-yield market; and
- The presence of industry leaders and secular “winners” in the convertibles space.
- Low exposure to traditionally more inflation-sensitive sectors like commodities (e.g., energy, metals & mining) and industrials, as persistent inflation continues to pose a headwind for many other asset classes.
- Low sensitivity to changes in interest rates, which historically (in contrast to many other fixed income sectors) has often led to strong convertibles performance in rising-rate settings like today’s.
- Generally favorable corporate fundamentals, including:
- Better-quality balance sheets for convertible issuers as a group versus their high yield counterparts; and
- An environment that remains ripe for M&A and shareholder-friendly events, from which convertibles’ equity component may benefit.
- The likelihood of a resumption of robust primary issuance in the months to come, given recent accounting rule changes that no longer require issuers to bifurcate equity and credit components.
Figure 1
Risks to our outlook
The “bear case” risk factors that we’re watching most closely these days include:
- A mixed global macroeconomic picture, where falling consumer confidence and other leading economic indicators may signal increased global recession risk; and
- Energy prices continuing to climb amid ongoing geopolitical turmoil, perhaps pushing the global economy toward recession and/or “stagflation” (rising inflation paired with slowing growth).
However, it’s always possible that a severe economic shock could cause global central banks to delay their monetary policy tightening efforts or even reverse course on their planned interest-rate hikes, which would likely help alleviate the risk of a global recession.
Bottom line on convertibles
Today’s uncertain landscape is not without potential risks for convertible bond investors to be mindful of, but as of this writing, we are cautiously optimistic on global convertibles’ performance prospects going forward. We will update our views if/as market conditions warrant in the months ahead.
1Asset classes are proxied by the following indices: Global convertibles: ICE BofA Global 300 Convertible Index; Global high yield: ICE BofA Global High Yield Index; Global investment-grade corporates: ICE BofA Global Corporate Index. Sources: Bloomberg, BofA Global Research. Data as of 31 March 2022. | 2Convexity is a measure of the curvature in the relationship between fixed income asset prices and their current yields, showing how a bond’s duration changes as its yield changes. For example, a bond is said to have positive convexity if its duration increases as its yield decreases. Positive convexity generally leads to greater increases in bond prices.
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