- A year with lacklustre upside participation is coming to its end
- We expect strong primary convertible bond issuance to continue into 2022
- Convertibles can protect against potential higher volatility in 2022
Convertible bonds have been somewhat lacklustre in 2021. At the end of November, global equity markets as measured by the MSCI were up 12.4%. Balanced convertible bonds traditionally have an upside participation of 60% and above. Yet, the Refinitiv Global Focus index decreased -0.3% in US dollars. Perhaps some moderation was due, after a record 23% gain in 2020.
At the same time, convertibles have exhibited decent protection. When stock markets dipped in September due to inflationary fears, convertibles protected investors from about 60% of the equity market losses. Similar protection levels came into play when markets reacted to the Omicron Covid variant at the end of November. This gives us a lot of comfort that convertibles will also hold effectively on the downside if, or more likely when equity markets see higher volatility and set-backs next year.
Looking back and combining the stellar performance in 2020 with this year, risk adjusted returns of convertibles since 2020 look convincing. In the long-term, the asset class has demonstrated its combination of downside protection and upside participation.
Elevated issuance remains key factor
One significant trend that started in 2020, which drove convertible bond markets throughout 2021, and which we think will continue is elevated volumes of new issuance.
Companies are racing to the market to ensure refinancing. 2021 has seen a record volume of $170 billion of new convertibles launched. We expect that figure to be around $165 billion for 2022. The overall universe of convertible bonds has now grown to close to $700 billion[1].
Usually, a strong rally on stock markets also drives up the valuations of convertibles into a territory where market prices range 3% to 6% above their fair values. The significant primary market liquidity has, however, prevented this from happening and kept valuations low. We are now witnessing a surprising broad misevaluation based on high supply. This discount is especially notable in US technology names.
This valuation gap will deliver performance in either market environment. Should markets turn south, the downside protection is strengthened and the current discounts act as an additional cushion. Should the market continue to rally, there usually is a strong reversion to the mean and the current misevaluation will bring another performance boost.
Traditionally, the primary market in convertible bonds is very dynamic and does focus on certain sectors almost in a wave-like pattern. A prime example was the IT sector in 2020, with significant convertible bond issuance volumes into the strong Nasdaq rally. This trend remained in place in 2021 with more than 20% of the overall new issuance volume this year coming from the IT sector. We believe that this could shift next year and in the longer-term.
Sustainability and ESG increasingly prominent
The world needs strong capital flows into companies enabling and contributing to environmental change if we want to have any chance of meeting the Paris target to limit the rise in global temperatures to 1.5 degrees. In terms of issuing sectors, there could well be a dynamic shift towards materials, energy, and equipment investments. With prolonged inflation, these sectors should need investment capital and could easily tap the convertible bond market to refinance.
There are various components to the sustainability or environmental, social and governance (ESG) theme. As well as building the infrastructure, the filters, the batteries, and the array of other technology equipment, we need capital investment into mining the lithium, silver and copper that will be needed, and – contentious though it may be – to build gas and nuclear power stations to power the transition.
Our expert think we need to finance more than 2% of global GDP into the early 2030s. This will almost certainly present opportunities for convertible bond investors as companies look to finance the ESG transition.
The late stages of 2021 saw stock markets making new highs. However, the good performance numbers are based on a handful of companies only. There is little market breadth. At the same time, there are numerous potential triggers for a set-back: supply-chain problems, renewed lock-downs, inflationary fears, central bank tapering and potentially tightening, energy supply problems, and highly leveraged equity markets with significant volumes in options. Markets do seem to reflect a degree of irrational exuberance.
This makes it easy to forecast at least one variable for next year: volatility is likely to be high as we will see set-back(s) in equity markets. In such an event, usually all risk assets sell-off simultaneously, and prices drop across the spectrum of stocks, bonds, convertibles, gold, and risk assets.
We would not be surprised to see indiscriminate, across the board sell-offs in 2022. In such moments, there are few places to hide with even diversification offering little protection. The “built-in” safety net of convertible bonds can absorb some part of downward shocks. This, in our view, is going to be important in 2022 and could make convertibles a valuable asset class for the year ahead.
[1] Source: Refinitiv, Global Issuance Statistics November 2021
