The case for European convertible bonds

 

 

“The equity market correction in October and additional profit-taking in the convertible bond space have affected the asset class in ways which we believe are not reasonable. Consequently, convertible bonds’ implied volatility has decreased sharply across the board, and specifically in Europe, only a few points away from September 2008 levels”, says Nicolas Delrue, Investment Specialist, Convertible Bonds, UBP.

In October, the sharp equity market decline has led to a broad correction in convertible bond valuations. This phenomenon has been further exacerbated by additional profit taking in the convertible space, which has caused convertible bonds’ implied volatility (“IV”) to nosedive. While this correction has affected all convertible bond markets, Europe was the hardest hit: from April to mid-October 2014, the European convertible bond market’s implied volatility fell from 34% down to less than 24% (source: Nomura).

This decline in convertible bonds’ implied volatility is counter-intuitive as, in contrast, volatility levels are spiking across the board. We believe this discrepancy should not be overlooked. Indeed, when investors are eager to buy protection, the price of listed options increases. This is evidenced by the spiking of the V2X (measure of volatility in the Eurozone, based on the Euro Stoxx 50 Index’s options, also referred to as the “Fear Gauge”). As this is happening at a time when convertible bonds’ implied volatility is decreasing due to the recent selling pressure on convertible bonds, it creates a “scissor effect”, accentuating the relative cheapness of convertible bonds’ optional features compared to listed options.

A window of opportunity reopens in Europe

The correction in convertible bonds’ implied volatility – in Europe especially – has come at a cost on the optional features front, consequently putting pressure on the asset class’ performance.

The direct consequence is that the asset class’ yield-to-maturity level has surged and that today it is still possible to build up a portfolio of defensive European convertible bonds displaying a yield pick-up versus equivalent straight bonds. This exceptional situation highlights that defensive convertible bonds are much cheaper than straight bonds, or in other words, that a whole segment of the European convertible bond universe still offers the possibility of benefiting from optional features which, in our view, are not priced in versus straight bond valuations.

In our opinion, the correction was not supported by any major change in economic indicators. Instead, we believe the current situation reflects general concern about the future action of the Federal Reserve, whose recent speeches have fuelled markets’ increasing volatility. On the corporate front, we have been pleasantly surprised by third-quarter S&P 500 earnings, which exhibit a trend that is above market expectations.

In a mid- to long-term timeframe, we believe that the correction in convertible bonds was excessive and that strong valuation opportunities can be found in the asset class, especially in Europe, where implied volatility has dropped the most lately.

We find the combination of these elements makes the case for convertible bonds, across the equity-sensitivity spectrum.

-       For investors looking for an alternative to traditional bond investments, attractive valuations combined with enhanced yield-to-maturity levels in the defensive segment of the European convertible bond market are factors supporting the current strong entry point to the asset class.

-       For investors looking for an alternative to equities, convertible bond strategies with generally higher equity-sensitivity, either in Europe or at global level, would allow minimally volatile access to stock markets, which we consider have declined excessively.

The current environment thus represents a good entry point in the market: while today European convertibles are catching up some of this distressed value, the European convertible bond space still exhibits a strong opportunity. European equity sensitivity is moderate (39%), yields are high in relative terms, especially in comparison to the US (yield to put/maturity of -2.9% versus -9.0% in the US) and duration is low, at 3.2 years (source: Thomson Reuters Convertible Indices).

 

About Nicolas Delrue

Nicolas Delrue is an Investment Specialist for Convertible Bonds at Union Bancaire Privée (UBP), a leading Swiss private bank with regional offices in Dubai and Beirut. In his role, he represents the portfolio management team inside and outside UPB. He is based in Paris. He previously worked as an investment specialist for the convertible bond desk at Fortis investments and as an investment specialist for the single strategy hedge fund business at SG AM Alternative Investments. His previous experience includes debt capital markets for the Caisse des Dépots et Consignations, an analyst position for a Venture firm and admission to listings at the Paris Stock Exchange.

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