"Assessing the opportunity to create a buy and hold fund on convertible bonds"

Turbulent times in the stock market often bring new opportunities for managers. However, it is better to look twice before following an investment idea that may seem very attractive at first glance. Especially when it comes to boosting savings that are sometimes stagnating.

Here are some explanations.

As a specialist in convertible bonds, wasn't the downturn in the financial markets an opportunistic buying signal for you?

As a manager that focuses on fundamentals, I am always on the lookout for new opportunities. Between 2019 and 2021, the convertible bond market was particularly dynamic in terms of new issues. However, in recent months, the stock market reversal of some technology companies that issue convertible bonds has caught my attention. This was enough for me to decide, three months ago, to build "theoretical" portfolios in order to observe what could be achieved by holding certain bonds until their maturity. At the time, the portfolios were showing returns of between 5% and 7%.

So an opportunity seemed to be emerging?

Yes, it did. Or at least the beginning of an opportunity. The yields at the time were in line with what one would expect given the average level of credit spreads. If we take the same portfolios today, the yields are now between 8% and 11% ! While at first glance this seems much more attractive, these levels also reflect the general deterioration of the market since the beginning of the year.

These figures seem sufficiently encouraging that some may be considering launching buy & hold funds with convertible bonds. This is a phenomenon that we see every few years in this asset class.?

What do you think about it?

If you look only at this angle of return, the idea sounds attractive. But only at first glance.

How so?

When I set up these portfolios for observation purposes, I thought that the situation would deteriorate more for?convertibles which had what I call a high-yield bond profile. In other words, that it would be possible to benefit at launch from a discount or a higher additional yield than the levels observed on average for other bonds. Historically, these bonds offer, for an equivalent life and rating, 2% more yield at maturity than traditional bonds.?

So the extra yield is not high enough today to offer a buy and hold strategy on convertible bonds under the best conditions?

That’s right. While there is some additional yield, which compensates for the lower (or even zero!) coupons received throughout the life of the loan,?this excess yield?is the same today as it was in January. This is itself identical to the level observed from a historical point of view.

As a result, yields on high yield bonds are just as attractive as those on convertible bonds, which some might consider putting into a buy & hold fund.

What would investors who disagree with your view of the market be exposed to?

We have launched and managed many maturity funds in the past based on this buy & hold principle. Experience has taught us that two conditions must be met for this type of strategy to be more attractive than investing in traditional high yield bonds. This is not yet the case.

Can you explain more precisely these two conditions to which you refer?

To be successful with your buy & hold fund, you first need to favour maturities of less than or close to 3 years. Indeed, the convertible bonds in question often pay no coupon and are also trading?"below par", i.e. at a price below their nominal value. The idea is therefore to buy these products and to put oneself in a position to see them rapidly converge towards par. Today this is not the case at all as the maturities of the bonds are concentrated around 2026. In other words, investors risk buying securities that will not appreciate in the next two years.

And the second condition?

The second condition is to be able to benefit from a market dislocation in order to make the product more attractive than classic high yield bonds. I don't think we are there yet.

To date, 32% of the global convertible bond market is yielding more than 5% (in dollars) and 10% of the market is even yielding more than 10% ! While these figures are certainly off the charts, they reflect the fact that a large part of the convertible market is made up of securities issued by companies in the technology sector. After reaching stratospheric valuation levels, the sector has experienced a sharp correction on the stock market over the past six months. But this decline may be just the first step before a larger descent. If this were to be the case, we could then witness a phenomenon of investor capitulation. Such an event would provide a window of opportunity to launch a product that is very competitive with traditional high yield. In the meantime, it is advisable to remain attentive.

What are you doing in your bond funds today?

In our portfolios, we?are still very cautious. For example, the Sustainable Income Opportunities portfolio is fully protected against rising European interest rates. And we believe that while high yield offers attractive levels, it remains very vulnerable in this context of slowing growth.?

We are also keeping a close eye on some of the stocks that we have put on watch by creating the ??theoretical?? portfolios that I mentioned at the beginning of our exchange. These are indeed very promising opportunities that have to compete with all those that may appear in the credit market. To date, we have only taken a few positions. We know that we will have to wait before we can deploy this strategy in an optimal way and then take advantage of the best opportunities that will inevitably arise, given the wealth of convertible bonds available.

In the meantime, the investment grade market in the US seems to have become very attractive again and represents a good opportunity to build positions. We are gradually increasing our exposure to this segment.

As you can see, the next twelve months promise to be very exciting!