Market volatility makes for difficult decisions for investors
On the one hand equity markets are uncertain and big stories like the BP oil spill have highlighted the need to be aware of stock-specific risk. Meanwhile, the attractiveness of sovereign bonds has been hit by both the troubled outlook for certain markets such as the PIIGS (Portugal, Italy, Ireland, Greece and Spain) and by historically low yields on ‘safe haven' sovereigns like US Treasuries and German bunds.
In such an environment, convertibles merit serious consideration, says Anja Eijking, manager of the F&C Global Convertible Bond Fund. "Whilst convertibles have not been untouched by the recent developments, seeing some fall in valuations, they have an attractive total return potential and in a much more favourable risk adjusted environment," she comments.
In comparison to other asset classes, Eijking explains that convertibles enjoy the advantage of a degree of downside protection in the form of bond floors. The theoretical downside risk of a convertible from issuance to maturity is limited to an opportunity cost as the coupon payment on a convertible is lower compared to a corporate bond. In exchange the convertible offers unlimited upside potential as it is able to participate defensively in any equity gains - which can be expected to resume again once current market concerns are alleviated.
Recent additions to the portfolio of the Luxembourg Sicav include KFW/Deutsche Post, Microsoft, Arcelor Mittal and cyclical companies that had traded down substantially on the back of what Eijking sees as an overreaction to reduced global growth outlook expectations.
In general, says Eijking, investors in convertibles can expect to participate in about two-thirds of the upside of an underlying equity compared to around one-third participation in the downside.
The F&C Global Convertible Bond Fund's track record demonstrates the beneficial risk/reward characteristics of the asset class. Over the extremely dislocated markets of 2008/9, the Fund returned +4.9% versus an equity market return of -23%. (Past performance is not a guide to the future. Convertibles are not risk-free and the value of investments can fall as well as rise.)
Commenting on the outlook for convertibles, Eijking says: "In the near term, we expect markets to remain volatile and new issues constrained, but we believe the worst should be over and are cautiously optimistic about the future. The US and Asian economies should continue to drive a global recovery and the euro's depreciation should help export prospects. The volatility in the markets creates good opportunities to benefit from the favourable risk/reward features of convertibles and the upside potential/downside risk balance has become even more compelling following the cheapening of valuations."
In an anticipated scenario of recovering equity markets, she concludes, convertibles should benefit strongly from rising share prices and as convertibles enjoy low duration compared with sovereign and corporate bonds, the valuation risk in a rising bond yield environment is lower.