FLASH – G Fund European Convertible Bonds

Convertible bonds in an environment of low interest rates

2017 has been marked by strong and simultaneous economic growth in the developed countries, supported by monetary policies that have remained globally more accommodative than expected.

In the euro zone, we can see that current prices on the fixed income markets, both for sovereign and corporate debt, are clearly in expensive territory. This can be explained in particular by the distortions induced by the massive asset purchase programme of the ECB. Investors have been forced to step down some rungs on the credit quality ladder to bypass the poor perspectives of return of Fixed Income portfolios.

Meanwhile, convertible bonds remained relatively unspoiled since they were not eligible for the Quantitative Easing^[1] of the ECB. In this context, convertible bonds provide added value to a fixed income portfolio, thanks to their convex profile, by taking part in the rise of equity markets. In the opposite case, the bond floor allows to dampen market bearish phases to a certain extent.

By the way, the convexity of convertible bonds succeeded in achieving high performances, together with a reduced volatility relative to equity, the result is that the performance/risk ratios are better than for a benchmark equity index (see table below). We can note that convertible bonds deliver performance that is both less volatile than equity and higher than sovereign bonds over the last three years.

Source : Groupama AM of 17 Novembre 2017

Source : Bloomberg, Data as of 17 Novembre 2017

 

Groupama AM Convertible Bonds Expertise : which positioning ?

In such an environment, wide leeways are used for deploying the various performance engines at best and reinforcing the convexity of our fund: G Fund European Convertible Bonds:

1.Portfolio Construction

The macroeconomic environment is currently buoyant. Despite this, market values are already high and even entering the overpriced zone in the United States, thereby making these markets fragile. So, we have given more importance to an approach based on stock-picking than on beta^[2]: the delta^[3] of the stock is therefore moderate and close to its benchmark index.

We also add convexity to the portfolio in two ways: first, we avoid convertibles that are judged to be overpriced (for example BP, Carrefour, Technip FMC etc.), which are no longer convex, and we construct our own replicated convertibles, which today consists of 20% of equity risk of the portfolio. Second, we implement hedging strategies in the portfolio (put options on Eurostoxx 50 for example), in the aim of reducing potential market shocks.

Considering credit market as expensive, we have significantly reduced allocation to the fixed income leg of our replicated convertibles (5% of the portfolio), and we prefer to maintain a substantial liquidity pocket, enabling us to seize opportunities on the primary convertible market.

Finally, the portfolio is partly hedged against rising interest rates via futures contracts on BOBL^[4] and OAT^[5]

2. Sector selection stock-picking

The underlying pool of convertible bonds is heavily weighted towards the real-estate sector: although we are under-exposed on this sector, we have a strong conviction in the potential of the German residential property sector, and so we have invested significantly in this sector via well-known big-name companies, such as Deutsche Wohnen or Leg Immobilien, as well as via several medium-sized companies that are less highly valued, such as Aroundtown, Tag Immobilien etc.. Conversely, we avoid investing in commercial real-estate, which we believe could suffer from the development of e-commerce.

Moreover, our current stock-picking approach focuses primarily on companies operating in markets that we consider highly promising and still growing. This is the case, in particular, of Seb, world leader in small household appliances, which has two key growth engines – its presence in Asia and its strategy of mergers and acquisitions. It is also the case of Remy Cointreau, leader in the spirits market, which is tapping into the growth of the Chinese market by specializing in the top of the range. We also like Covestro, world leader in the supply of polymers, which offers innovative products enabling it to have a consistent pricing power on a market where demand is growing faster than the supply.

 

3. A cautious positioning on political risks

The negotiations between the United Kingdom and the European Union remain difficult to assess. The sterling pound has lost almost 16% of its value since the eve of the Brexit vote in June 2016, weakening the purchasing power of British consumers. The residential and office property markets are beginning to suffer from this situation.  We are therefore under-exposed to UK securities (2.1% exposure to convertible bonds in G Fund European Convertible Bonds, compared to 9.2% for its benchmark index at the end of November 2017), in particular in the real-estate sector. We are also partly hedged against pound.

Moreover, we have long adopted a prudent approach to the peripheral countries.  In the short term, the elections in Catalonia and subsequently in Italy must be watched closely. In the long term, the improvement in the macroeconomic situation in Europe could trigger a rise in euro interest rates, which will be difficult to digest for countries like Italy or Spain. So, we are under-exposed to these countries, especially in the bond component, and are steering clear of securities such as Telecom Italia.

 

4. USD positioning

The weight of dollar issues in the reference index is close to 20%. After benefiting from the rise in the US dollar over the last few years, we have been partly hedging our position since early 2017: the growth differential is now more advantageous in the eurozone compared to the United States, which are closer to the end of their economic expansion cycle.

In this context, and once the Italian political risk averted, we are not excluding the possibility that the euro might appreciate further in 2018.

 

5. Mergers et acquisitions

Our management process also takes the theme of M&A into consideration. We regularly look for opportunities in this segment, and we think that the environment today is favourable to this type of operation: while some businesses are continuing to experience a combination of downward pressure on prices and robust competition, financing costs are very low, acting as an incentive to operations of external growth, which can rapidly prove accretive.

For example, we have recently benefited from the merger between United Internet and Drillisch. On the day of the announcement, the Drillisch convertible bond outperformed its equity, thanks to its  “ratchet^[6]” clause. We also hold several securities for which we think there is a potential for merger/acquisition, such as NH Hotel Group, which is in fact currently the object of a projected merger with Barcelo. Other companies in the portfolio are attractive to us, both because of their intrinsic quality and for their M&A potential, due to “ratchet” clauses: this is the case, for example, of Subsea 7, Qiagen, AMS, German real-estate companies etc.

 

Performance

In this context, G Fund European Convertible Bonds (share class IC EUR – LU0571100584) could benefit entirely from its convexity, by successfully adapting to the different trends and movements on the markets. Thanks to the fund’s specific management process, the fund managers have been able to add further convexity.

This has enabled the fund to clearly outperform its benchmark reference index, Exane Convertibles Europe: +17.97% over 5 years and +10.48% over 3 years (as of 17 November 2017, IC-C-EUR class).

 

Since the realized volatility of the portfolio is close to that of its reference index, the risk/return ratios are significantly improved:

Thanks to our investment process, we add convexity to the portfolio, as is shown in the table below:

 

The above table highlights this convexity through the equity market “bull^[7]” and “bear^[8]” phases that we have experienced since 2013. This can be seen from the last column corresponding to the percentage of participation in the fund’s performance of G Fund European Convertible Bonds in the overall performance of the equity markets (reference index: Eurostoxx 50 Dividends Reinvested).

Outlook 2018

In the Euro Zone, leading indicators return to historical highs, while, in the United States, the enthusiasm generated by Donald Trump tax-cut plan is expected to extend the current economic cycle. 2008 should therefore continue on the 2017 trend, with maintained preference for asset classes sensitive to equity.

Nevertheless, geopolitical tensions persist, acting as a booster shot during the over-enthusiastic market phases: the Italian elections and the Korean nuclear threat, among other factors, could increase volatility during 2018 and therefore put the markets under strain. Central bankers also seem to have the will to pursue their “roadmap” that is to say withdraw progressively from the markets, creating additional strains on the bonds markets.

In this context, we are continuing to adopt a prudent position regarding the sensitivity of the portfolio to interest rates. We also remain vigilant in our stock-picking, and we are seeking to avoid companies with a credit profile that we consider high-risk, such as Steinhoff and Astaldi

We believe that G Fund European Convertible Bonds seems well equipped to face the coming year, since it is able to participate in rising equity markets while demonstrating resilience during periods of high volatility.

 

For information, the main risks associated with the fund are equity risk, interest rate risk, credit risk, liquidity risk, derivative instrument risk and the inherent risk of investment in convertible bonds

 

 

¹ Quantitative Easing consists in massive purchases of debt instruments on the financial markets by a central bank; these instruments are in particular treasury bonds or high-quality “investment grade” corporate bonds.

² Beta is a risk measurement tool that indicates the extent to which an asset evolves in the same proportions as the market. 

³ Delta is a measure of the sensitivity of the price of a convertible bond to changes in the value of the underlying stock.

⁴ The “Bundesobligation” or “Bobl” are German sovereign bonds with an initial maturity of 5 years. 

⁵ “OAT” is a sovereign bond issued by the French state.

⁶ The “ratchet” clause protects convertible bond holders where there is a change of control of a company (in particular in the event of mergers and acquisitions) by upwardly adjusting the conversion rate of the convertible bond.

⁷ “Bull” market refers to an upward oriented market

⁸ “Bear” market refers to a downward oriented market

 

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