FI_Convertibles to take Centre Stage

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Convertibles to take Centre Stage

By Laurent Le Grin,
CEO DPAM France & Head of Convertible Bonds

In the asset management industry, we are always keen on analysing hypothetical scenarios. However, we believe it is time to take a step back and look at the real life scenario that the Covid-19 crisis has created for us. In recent months, across all asset classes, convertible bonds have stood out thanks to all their intrinsic qualities. Starting with the maximum drawdown, the loss of the MSCI Europe Net Total Return Index stands at 33.5% compared to a 12.5% decline for the Exane Eurozone Convertible Bond Index. On the graph below, one can see concretely how the convexity has worked out over the past months. As the equity market crashed, the options embedded in the convertible bonds decreased in value and the instruments traded like bonds. Thus, the bond floor, which is the discounted value of the coupons plus the redemption value, has provided protection against the fall in the underlying equity.

Graph 1: performance in 2020

Source: Bloomberg

After outperforming during the downturn, the convertible bond index has returned 10.9% since the lows of the end of March, pushing the year-to-date performance into positive territory at 0.9%. Meanwhile, the MSCI Europe and EUR high yield bonds remain in negative territory at -9.1% and -3% and EUR investment grade bonds returned 0.2%. Leading in terms of performance, convertible bonds are benefiting from the bond floor resistance, the strong recovery in the option-adjusted spread (OAS) and the equity optionality.

Table 1

Source: Bloomberg, MSCI Europe Net Total Return (NDDLE15 Index), Exane Euro (EZCIEZCI Index), Iboxx EUR 3-5 years (QW5E Index), Bloomberg Barclays High Yield Euro (LP01TREU Index), performance until 24.08.2020

So what now? While the US market has bounced back to historical highs, helped by an abundance of monetary and fiscal support, there is still a risk of significant drops in investor confidence and of Covid-related news that keep volatility at relatively elevated levels. Increasing exposure to the equity asset class is a thorny issue at such levels of valuation in the face of a more uncertain and longer reopening of the economy. We believe that due to their profile, convertible bonds may offer an interesting “recovery play” to complement straight equity and debt allocations.

First, convertibles look compelling right now from a valuation standpoint. The spread between the theoretical and real prices of convertibles creates attractive opportunities. That is why we see valuation as a greater source of alpha than medium-term risk for the asset class. If equity markets continue to rebound over the coming months, many convertibles could see their prices catch up, all the more so if the asset class attracts buying flows.

Second, the risk/return profile looks favourable compared to other asset classes. In a volatile economic recovery, the downside risk of convertible bonds is materially reduced versus a similar position in the underlying equity given convertibles’ higher seniority. Moreover, EUR investment grade bonds have soared over the last months, pushing the yield-to-worst from a peak of 2% to the January pre-crisis levels of 0.5%. Even the OAS in the EUR high yield market has reversed below the 20-year average at 468 basis points (bp) vs. 565 bp. In such a low yield environment in the straight debt market, the convertibles offer an opportunity for higher returns, especially as a higher volatility regime will support convertibles’ valuations.

Finally, a wave of new issues has not only flooded the market with new names but has also changed the nature of the European convertible bond universe over the last 12 months. You can see below how the sectorial breakdown of this universe has evolved over the year.

Graph 2

Source: Bloomberg

The communication services, materials, healthcare and industrial sectors represented 55% of the universe one year ago, while consumer discretionary, communication services, industrials and technology taken together now have the same weight. Important changes came from the IT sector, which represented only 6% of the universe compared to 11% now. The sector now counts promising investment cases like Worldline, Nexi, Besi or STMicroelectronics. One can say the same for the consumer discretionary sector with names like Zalando, Delivery Hero, Just Eat… With these new issues, the European convertible market has left the old economy behind and leaped into the digital economy.

Actually, the universe has widened so much that we have been able to segment it into two baskets. First, a growing number of companies that can be considered “Covid-19 Gainers” have come to the market this year. For example, Delivery Hero issued EUR 3.65 billion in convertible bonds, Yandex, USD 1.25 billion and HelloFresh, EUR 190 million. A few weeks ago, even Zalando issued two EUR 595 million in convertible bonds. These companies have benefited from the Covid-19 crisis due to the change in consumer behaviour from on-site shopping to online shopping and delivery. Companies negatively impacted by Covid-19 and companies that will benefit strongly from the recovery make up a second basket. Amadeus, Safran, MTU, Air France, Akka, Vinci or Sika and Outokumpu are part of what we call the “recovery play” basket. As we had decreased exposure to the second basket at the beginning of the turmoil, we are now making the opposite move as these companies would benefit from any vaccine announcement in September by AstraZeneca or in October by Moderna. You can see in the below table the names included in our two baskets.

Table 2

Source: Bloomberg

We believe that the food delivery sector, which benefited from the shift in consumption habits during the Covid-19 crisis, may underperform in the short term with the imminent arrival of vaccines that will give a positive psychological boost to the market. The Achilles heel of this industry is that credit can’t truly be monitored/forecast. Recovery value essentially depends on intangible assets. For Delivery Hero, the good news is materialized in the money, however any bad news will translate into asymmetric behavior from the stock, as credit will widen due to the uncertainty associated with the trajectory of EBITDA. We therefore clearly prefer Just Eat Takeaway and HelloFresh, as their mergers & acquisitions strategy follows a path of rationality. Zalando remains by far our preferred value because we believe it will benefit from the shift from traditional consumption to digital consumption.

All in all, the convertible bond asset class remains a one-of-a-kind opportunity in the uncertain world we are entering. The discount to theoretical prices in a low yield environment will attract new inflows looking for exposure to the winning companies that will shape the future of our economy. The right instrument with the right underlying asset, now is the sweet spot for the European convertible bond market.

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Convertibles to take Centre Stage