Flash – CONVERTIBLE BONDS

16/09/2020

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The benefits of the convexity provided by convertible bonds have never been more evident than during the COVID-19 crisis. For example, during the first quarter of 2020, convertibles proved to be particularly resilient, mainly due to their unique structure, which gives them an attractive risk/return profile.

AN ASSET CLASS THAT HAS PROVED ITS RESILIENCE DURING THE COVID-19 CRISIS

The benefits of the convexity provided by convertible bonds have never been more evident than during the COVID-19 crisis. For example, during the first quarter of 2020, convertibles proved to be particularly resilient, mainly due to their unique structure, which gives them an attractive risk/return profile.

Charts

Title: Performance of European equity indexes vs convertible bonds indexes since the beginning of the year (as on 31/08/2020)

Source: Bloomberg

The main global indexes suffered considerable losses, with the MSCI Europe down by as much as 32.6% (as on 18/03). On the fixed income markets, credit spreads widened substantially (the Xover index was over 700 bp on March 18th 2020). In this context, the intrinsic convexity of convertible bonds again played an effective role as a shock absorber. The Exane Europe index recorded a drop of -7.8% on 18/03, and the Exane Zone Euro index had negative performance of -7.1% over the same period. The bond floor therefore performed its function to full effect during this phase of stress on the market.

The excellent resilience of convertible bonds during strong market downturns enables them to perform better than, or very close to, equities over long periods, as can be seen in the graphs below.

Charts

Title: Performance of European equity indexes vs convertible bonds indexes over 3 years (as on 31/08/2020)

Source: Bloomberg

 

MSCI

Title: Performances of European equity indexes vs convertible bonds indexes over 5 years (as on 31/08/2020)

Source : Bloomberg

  

A DYNAMIC PRIMARY MARKET AND ATTRACTIVE VALUATION LEVELS

With more than 13 billion euros issued via a total of 29 issues since the beginning of the year [1]the primary market showed a good dynamic over this first half of 2020, despite the slowdown during February and March. The underlying pool of convertible bonds is now more diversified, with new issuers having a significant growth potential over the long term (Hellofresh, Zalando, Ocado, Zur Rose etc.).

At the same time, approximately 7.3 billion euros of capital were withdrawn from the market (redemption, conversion, exercise of call options etc.), which, has therefore led to an increase in the European convertible bonds universe.  

Tableau

Title: Primary market dynamics, YTD

Source : Groupama Asset Management

Moreover, during the market stress (March – April 2020), we observed a slight increase in the implicit volatility of convertible bonds, but to a far lesser extent than for the equivalent listed options. This major reduction in value, a first since 2012, was slightly reduced with equity markets recovering. Moreover, given that the primary market remained dynamic and the limited inflows towards the asset class, the convertible bonds universe still remains very attractive and, in our opinion, offers interesting entry points.

Despite the decline in growth outlooks due to COVID-19, the sanitary crisis that we are currently experiencing represents a clear accelerator of structural changes in the way we use energy and technologies. In this context, the convertible bonds universe offers investors a privileged access to companies whose activities are incorporated in those structural changes, where the long-term trends are also strong, such as e-commerce, home deliveries, video games, renewable energies etc.

Convertible bonds offers the ability to invest in companies that are at the heart of the digital and environmental transformation of the economy, while at the same time benefitting from the convexity of the asset class.

 

THE PERFORMANCE OF OUR FUNDS IN A PARTICULARLY UNCERTAIN MARKET ENVIRONMENT

Thanks to our investment process, which combines both top-down and bottom-up approaches, hedging strategies and a bucket of replicated convertible bonds, our convertible funds performed particularly well during the first eight months of 2020 and especially during the sharp fall in equity markets.

Since the beginning of the year, we have progressively increased our exposure to the sectors of residential real estate, technology and utilities, with the aim of providing support to the technological and environmental transitions. During the risk-off period, these sectors demonstrated their resilience and are partly responsible for the positive performance of the asset class. Moreover, we reinforced our hedging strategies at the beginning of the year and throughout the first six months, and we adopted a cautious position with lower delta levels than the indexes. This enabled the funds to outperform their respective indexes during the sharp drop of the markets February and March. Subsequently, during the recovery phase, the re-sensitization of the funds functioned well, as was the sectorial rotation that began mid-May.

 Graphique

Title: Performance YTD of our G Fund – European Convertible Bonds

Graphique

Titre : Performance YTD of our Groupama Convertibles fund 

Our top-down position as well as our bond picking (Cellnex, Wordline, Encavis, Neoen, Iberdrola, Hellofresh, Delivery Hero etc.) enabled our funds to further outperform their reference indexes by 255 bp in the case of Groupama Convertibles (YTD as on  31/08/2020) and +111bp for G Fund – European Convertible Bonds over the same period.

 

OUTLOOK 

Thanks to their positioning and reinforced convexity, our convertible funds performed very well during this period of high volatility. Today, there are still major uncertainties, even if the central banks and governments are showing their massive support (massive recovery plans, support for the sectors that are particularly hit by the health crisis, such as aviation and tourism, the purchase of sovereign debt and credit by central banks etc.).

In this context, we are maintaining an active investment strategy.

  • Return to a slightly lower than standard delta exposure in late June, together with the establishment of new hedging strategies. 
  • Duration risk remains slightly lower than for the reference indexes.
  • Convertibles are temporarily preferred (being lower priced due to the abundance of new issues), by comparison to the replicated bucket  (high implicit volatility on options).
  • Credit allocation remains historically low (about 5%), after being reinforced in March/April. We reduced it slightly in July. The cash pocket, although recently reduced, enables us to seize potential future opportunities, in particular on the primary market.
  • Structural underexposure to the peripheral countries is maintained but has been reduced following the exceptional measures put in place by the ECB.
  • To improve the convexity of the portfolios, hedging positions have been maintained to face potential market shocks.

 The main fund risks are :

  • Interest rate risk: A  rise in interest rates on the fixed income markets can lead to a fall in bond prices
  • Credit risk: Any downgrading of the issuer’s signature can have a negative impact on the value of the security
  • Liquidity risk: Depending on the specific period, bonds can be less liquid than certain equity markets, and this can affect the net asset value of the fund or compartment, in the case of large-scale redemptions.
  • Capital risk: The compartment or fund does not provide any guarantee or capital protection. Ultimately, investors might not recover their initial investment.
  • Risk intrinsic to investment in convertible bonds The elements determining the value of the convertible bonds (interest rates, trend in the prices of the underlying shares and trend in the price of the derivative integrated in the convertible bond) can lead to a reduction in the net asset value of the fund or compartment.

Equity risk: Variation in share values can have a positive or negative impact on the net asset value of the fund.

 

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