Max Pacella
Investment Analyst
Fixed Income
28 Oct, 2021

In a time when both equity and fixed income markets have shown considerable volatility, investors may be left wondering, “where do I look now?”.

Since the start of September, we have seen MSCI world move 5% up and down and US 10Y yields move from 1.3% to just over 1.6%, creating panic particularly towards the end of last month that there was nearly no safe haven.

Although the market doesn’t stay in one state forever, it’s always valuable for an investor to be aware of the tools at their disposal and potential allocations which may be defensive against an unfavourable capital market environment.

What if there was an exposure that offered a potential defensive positioning, whilst also allowing investors to capture some upside in the better times?

To quote that Old El Paso ad, “porque no los dos?”.

Which brings us to the subject of today’s note: convertible bonds.

What is a convertible bond?

Convertible bonds (or “convertibles”) have a unique risk/reward profile, given the link in the value of the bond to the underlying security whilst still maintaining an income component – but we get ahead of ourselves.

A convertible bond is a corporate bond with an embedded equity call option, which can be converted into a nominated quantity of common shares at the discretion of the bondholder.

The resulting security becomes a hybrid mix of equity-like and bond-like characteristics, depending on market conditions.

Convertibles are affected by fixed income inputs, such as interest rates and credit spreads, as well as equity market prices and volatility.

As such, an investor is in a sense taking on the blended risk/reward characteristics of both asset classes.

With that being said, the below capital order chart does show that the investor ranks only just above equity in terms of risk and liquidation priority:

Source: Mason Stevens

Looking first at the bond component, convertibles are normally issued as fixed rate debt (with the majority being USD-denominated), at generally a lower yield than a regular corporate bond.

The reason is that you have the inbuilt option structure offering the potential for greater capital upside through conversion to equity.

In a sense, this disparity in yield between regular and corporate bonds can be considered the equivalent of an option premium – called an “option-adjusted spread” or OAS.

For example:

  • Company A issues two lines of debt:
    o A subordinated bond, with a coupon of BBSW + 5.0% p.a.
    o A convertible bond, with a coupon of BBSW + 2.0% p.a.

The 3.0% difference in yield is the premium associated with being able to convert to Company A shares at the borrower’s discretion – whether that premium is worthwhile of course depends on the relative value of the stock and perceived value for the investor in the future.

If we then move on to the equity component of convertibles, the value of the bond is tied to the option component as well as just the yield of the debt.

If the underlying equity does well, the option moves “into the money” and creates capital upside for the investor. On the reverse, however, if the underlying equity does poorly, then the bond still maintains the value of the debt and its corresponding yield.

The equity sensitivity of a convertible is not static and is linked to the performance of the equity component particularly.

The value (and volatility thereof) becomes more equity-like when the underlying equity is doing well and the option is in the money (which we will touch on in the correlation study in a moment) – whereas the value becomes more bond-like in sideways or negative equity markets when the option is out of the money and only the income component is relevant to the value of the investment

There is an asymmetric return profile here where you have downside “protected” by the value of the debt, and upside facilitated by a rise in the value of the equity.

The trade-off is the potential that the equity does not perform, and you have incurred the opportunity cost of taking the lower-yielding convertible over a regular corporate bond from the same issuer.

Why issue Convertibles?

For an issuer, convertibles can be an effective way to lock in several key benefits across debt and equity components of their business.

Since convertibles are issued at a lower yield (or cost to borrow, from the perspective of the issuer), then issuers can take the opportunity to acquire cheap funding from the market as an alternative to taking on larger volumes of straight corporate debt.

The price to convert from debt to equity is also generally at a higher price than that of a rights issue strike price, which may lessen the equity dilution for the company – the dilution will also be deferred, since all debt holders may not immediately (or at all) convert, whereas rights issuance will create an immediately higher volume of voting shares.

As an example of a convertible issuance from late 2020:

IssuerFlight Centre Travel Group Ltd (FLT:ASX)
Offering$400m AUD
StructureConvertible Bonds due 2027
Coupon/Yield2.25 – 3.00% per annum (fixed)
Investor Put OptionAt the end of Year 4
Conversion Premium30 – 35% over the Reference Share Price

This was a 7-year bond yielding 2.25 – 3.00% per annum issued by Flight Centre during a time when markets remained negative on travel. After four years, the investor could then convert the option to buy FLT:ASX at a 30% discount.

What about Hybrids?

Many Mason Stevens clients are familiar with domestic bank hybrids, such as the recent Westpac Capital Notes 8 (WBCPK).

Are our domestic bank hybrids not the same thing as convertibles?

Not quite.

There are two primary differences that you’ll see between something like WBCPK versus a more standard convertible bond.

Firstly, you have the right of conversion.

Convertible bond owners decide if they want to convert or not, they may choose to simply hold the debt.

For a bank hybrid, these generally have a nominated date at which they will convert or be called (for example, WBCPK has a call date of 21 June 2032 despite being a perpetual note), or investors may roll into a new hybrid issuance.

Secondly, conversion in convertible bonds would only occur when the underlying equity has done well, so the value of the option is above “par” i.e. you would not convert in times of market stress/

This is unlike bank hybrids, which often force conversion during the “worst times” for the underlying equity, but investors are paid a correspondingly higher yield for this reason.

Correlation

As mentioned before, the equity sensitivity of convertibles is not static.

During rallying equity markets, convertible bonds tend to be more correlated (have a higher beta) to equities, since the option associated with the bond is in the money and creating that asymmetric upside we discussed.

In sideways or negative equity markets, the correlation is closer to fixed income markets as the value of the convertible is driven primarily by corporate credit spreads and the underlying interest rate environment.

The table below shows the correlation of convertibles over the last three years, a time in which equities have broadly done well:

Source: Mason Stevens, Bloomberg

The correlation to equity indexes is much higher than that of broad fixed income indexes over the last three years, likely thanks to equity markets rallying and creating option value.

Converting to Convertibles

Convertible bonds are certainly a unique asset, not fully equity, not fully debt, but somewhere in the middle trying to provide good qualities from both asset classes.

Though perhaps a ‘satellite’ exposure alongside a fixed income or equity portfolio, these bonds do offer some compelling characteristics to a multi-asset portfolio.

As always, our fixed income team are available to assist in any questions about the mechanics or market for such a security, as well as potential exposures which might exist in a direct or managed format.

The views expressed in this article are the views of the stated author as at the date published and are subject to change based on markets and other conditions. Past performance is not a reliable indicator of future performance. Mason Stevens is only providing general advice in providing this information. You should consider this information, along with all your other investments and strategies when assessing the appropriateness of the information to your individual circumstances. Mason Stevens and its associates and their respective directors and other staff each declare that they may hold interests in securities and/or earn fees or other benefits from transactions arising as a result of information contained in this article.