View more on these topics

Investment analysis: Looking under the bonnet of convertibles

As fund managers slash their duration, lower their ratings criteria for bonds and consider different types of debt, convertibles have experienced a surge in popularity

With bond yields universally low, investors have been forced to look elsewhere in the fixed income world for their returns. 

As fund managers slash their duration, lower their ratings criteria for bonds and consider different types of debt, convertibles have enjoyed a surge in popularity.

Convertible bonds are fixed income securities with both bond and equity characteristics that can be converted by their holder into a specified number of shares of common stock from the issuing company or into cash of equal value.

As with all types of bonds there are variations within convertibles, and one form of convertible bond currently attracting interest from investors is contingent convertibles, or “cocos”.

Cocos are automatically converted when a certain contingent is reached – such as a specified share price being exceeded over a certain timeframe.

According to data from Lipper, March saw the highest monthly net inflows into funds with a focus on convertible bonds registered for sale in Europe for three years. 

During that month, such funds experienced £1.8bn net inflows.

But these bonds have attracted criticism, with suggestions that their rising success could be symptomatic of a possible bubble.

Canaccord Genuity Wealth Management investment director Justin Oliver says: “We like strategic bond funds and we have to be conscious of the risks they are taking. 

“Some of the yields on cocos are 5 per cent and there are massive risks there.

“In general, the investment community feels the bubble is in government bonds. I argue it could potentially be in new structures, such as cocos. 

“It has some of the classic signs of a bubble. We are seeing their issuance in the periphery of Europe – a Greek bank issuing a coco bond makes me struggle to find anything riskier.”

Kames Capital fund manager David Roberts also sees some risks from this type of fixed income and says its success has been tied to recent strong performance in equity markets.

Roberts, who co-manages the £687m Kames Strategic Bond fund, says: “In some cases these instruments act much like equities, performing well under strong market conditions and entailing significant downside risk when it is not. Under 2008 or 2009 conditions, many of these instruments would be written off, with little probability of recovering any money.

“Many of the rabbits caught in the headlights of the crisis have now left the industry, leaving a relatively unscarred generation to shape the future.”

F&C multi-manager Rob Burdett has no allocation to convertible bonds or cocos and prefers to keep his fixed income and equity exposure separate within his portfolio.

Burdett says: “We tend to keep it simple. This means we may miss out but we prefer a cleaner approach to our asset allocation.

“People who buy these for the bond element get burnt if the equity aspect takes over. But never say never. When you have bond yields at record low levels, people are going to look around at whatever is left.”

Rathbones fund manager Bryn Jones is wary of the word bubble being used to describe the current situation around convertibles and argues the bonds can benefit investors. Jones, who co-manages the £57m Rathbones Strategic Bond fund, says: “With convertibles, they tend to have a low coupon, with a bond floor and an equity upside. 

“From an equity investing perspective, they provide downside protection so they can appear attractive.  

“For bond investors they can look more risky because equities appear quite frothy.”

With convertibles being linked to equity prices – which have been rising across nearly all equity markets – there is an additional layer of risk to be considered.

Jones adds: “Cocos are a different matter. You do not get equity upside with a coco, all you get is equity downside. “My concern is investors in cocos might not understand the risks they are open to.

“There is a significant danger that if something happens within the financial space you could potentially have your capital wiped out. Cocos were designed to be insurance contracts for banks. 

“It is quite worrying and I do not think it should have space in an investor’s portfolio.”

Hargreaves Lansdown head of investment analysis Richard Troue says he is not surprised investors have come to pay more attention to convertibles but argues they need to fully understand the potential risks.

Troue says: “It is becoming harder and harder to find value and with yields being squeezed you are almost getting things priced to perfection. 

“If it does turn out we are absolutely through the worst of the crisis and on firmer footing, then perhaps investors are being paid fully for the risks.

“But there is still potential for things to go wrong. 

“I do not know to what extent retail investors are invested in cocos but any exposure they might have could leave them at risk. It is definitely worth doing your homework on these things.”

Coco

Adviser View

Philippa-Gee-450.png

Philippa Gee Wealth Management managing director Philippa Gee says: 

The trouble with fixed income is there have already been bubbles forming elsewhere, such as gilts, and there is less room to manoeuvre. 

There could potentially be a bubble in convertibles and hopefully nobody would have a high allocation to that area. 

But it is not just convertibles. There are a lot of fixed income areas we are becoming more concerned about just because the market is being squeezed. 

We are increasingly using strategic bond fund managers for fixed income exposure but you have to be careful and know the risks being taken in the fund.

Newsletter

News and expert analysis straight to your inbox

Sign up

Comments

    Leave a comment