Introduction
Do you know what the US 10-year yield will be in six months’ time? No, seriously. Tell us. We’d love to know.
Ever since the Global Financial Crisis, low growth, low inflation and easy monetary policy have allowed investors to confidently predict the value of the US 10-year yield, which serves as proxy for the long-term cost of capital. If we know the US 10-year yield, we can make a rough but informed prediction about the price of other risk assets. Indeed, it is arguable that no other factor was as decisive in creating a decade long equity bull-market and perpetuating the 40-year bond bull market; with US 10-year yields at historic lows, it made perfect sense to be long risk assets at almost any price.
As consequence, we have exceptionally high volatility in all assets, particularly government rates, credit spreads and equity prices.
But we now live in a different world. Post-pandemic, rampant inflation, rising rates, war in Ukraine and now looming recession are making it almost impossible to convincingly predict the US 10-year yield. As consequence, we have exceptionally high volatility in all assets, particularly government rates, credit spreads and equity prices.
In our view, the situation requires investors to answer a simple question: do you feel lucky? If so, they are welcome to try and anticipate the likely direction of risk assets. But with prices so volatile, in the current situation they may be closer to punting than investing.
If they do not, the solution may be to find an investment style which thrives on volatility. At this point, we would highlight convertible bond arbitrage as being ideally suited for the current moment. Within this disruption lies opportunity, especially if investors have the flexibility and skills to identify and capture mispricing. The primary inputs to determine convertible bond value are rates, credit spread, equity volatility and stock price. These are now shifting more rapidly than they have done for a decade, creating mispricing opportunities. Rather than testing their luck on the direction of risk assets, investors should look to exploit the opportunities for active managers in the convertibles market.
Why Convertible Bonds Now?
The primary inputs to determine convertible bond value are rates, credit spreads, equity volatility and stock price. Constant moves in these assets can rapidly shift the theoretical value of convertibles, which as an asset class remain relatively inefficient. For instance, a 50bps increase in the risk-free curve could take days or weeks to manifest in trading prices. An adept manager might capture this inefficiency by adjusting rate hedges, adjusting convertible gross, or both. In contrast, investment grade credit trading incorporates the spot risk-free curve at the time of trade and simply trades in spread to risk-free terms. As such, convertible bonds can offer multiple arbitrage trading opportunities for active managers as opposed to their option free equivalent.
Currently, theoretical and market values are oscillating at historically high levels, creating dislocations. The US swap curve is rapidly changing, as rising inflation forces the Federal Reserve to enact a punishing hiking cycle (Figure 1). As consequence of rising rates and the worsening economic environment, credit spreads are widening (Figure 2). In contrast, equity volatility (demonstrated by the VIX index) has trended down, although the Fed’s commitment to tightening monetary policy has caused a further spike in volatility since the Jackson Hole conference (Figure 3).
Figure 1. US Swap Curve – 31 August Versus 1 January 2022
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Source: Bloomberg; as of 31 August.
Figure 2. Credit Spreads
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Source: Bloomberg; as of 31 August.
Figure 3. VIX Index
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Source: Bloomberg; as of 14 September 2022.
The current market is an exceptionally stressful environment in which mispricing abounds.
In short, the current market is an exceptionally stressful environment in which mispricing abounds. This was compounded earlier in the year during the equity selloff, which saw long-only convertible bond investors aggressively sell convertibles to reduce their exposure to the underlying stock. This led to several convertible bonds trading wider in spread than almost identical HY bonds (Figure 4). This situation is a pure arbitrage, since both the HY and convertible were of the same seniority, and the equity option embedded in the convertible should have some economic value. In effect, equity options were briefly selling for negative value.
Figure 4. Yields of Convertible Bond Versus HY Bond of Same Seniority - Selected
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Source: Bloomberg; as of 14 September 2022.
The same situation can be seen in the bonds of an automotive manufacturer of the same seniority and due in 2026. Using the option-implied volatility as our equity volatility input, we can see sharp selloffs in the convertible bond implied credit spread around periods of equity volatility, leading to underperformance compared to the pari-passu straight bond, before a slow convergence back towards fair value (Figure 5).
Figure 5. Automotive Bonds – Option Adjusted Spread, Convertible Versus Straight Bond
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Source: Bloomberg; as of 14 September 2022.
Do You Feel Lucky?
This poses a question to investors (who, rightly or wrongly, almost always associate good luck with bull markets): do you feel lucky? Will volatility stay low? If so, they can relax.
But we would argue that investors should stop associating good fortune with equity stability, and instead, choose to associate their fortunes with convertible bond arbitrage instead. As volatility persists, so will mispricing. And there are more than enough reasons why it may stick around for a while. With US CPI inflation at over 8% year-on-year, we see very little let up in the current direction of monetary policy. This is driving continued volatility in the swap curve, with rate volatility the highest it has been for a decade. Fed Chair Jerome Powell’s consistently hawkish tone has sparked continuing equity volatility. Indeed on the day of his Jackson Hole conference speech, the S&P 500 sold off by nearly 4%. Continued disruption to global food and energy supplies may be ongoing, and we may see multiple countries in recession by the end of the year. The war in Ukraine and US-China tensions add further fuel to the macro volatility fire. As recession hits, we can expect credit spreads to blow out, as more and more companies experience dwindling cashflows and deteriorating coverage ratios.
As recession hits, we can expect credit spreads to blow out.
As such, we expect more dislocations in the convertible bond asset class. Given the disjointed nature of pricing, further rate volatility and equity selloffs will likely produce both more opportunities to purchase convertibles below their fair value, and periods of stabilisation for this value to crystalise.
The Tailwind: Issuance Trends in a World of High-Cost Debt
However, mispricing may not be the only support to convertible bonds. The advent of unorthodox monetary policy in the wake of the Global Financial Crisis (‘GFC’) has significantly impacted the convertibles market. Since 2008 the convertibles market size has actually shrunk while HY in comparison has quadrupled in size. Prior to 2003 the convertible market was actually larger than HY. Persistently low interest rates have made it much more attractive to issue high yield debt for corporate issues. In addition, investors desperately searching for yield moved up the risk curve and created a self-reinforcing cycle, happy to buy the glut of HY issuance (Figure 6-7).
Figure 6. Market Size – Convertibles Versus HY (USD Billion)
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Source: Bloomberg, Man GLG; as of 14 September 2022.
Figure 7. Convertibles as a Percentage of the HY Market
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Source: Bloomberg, Man GLG; as of 14 September 2022.
However, in a normalised rate world, we may see issuance split more evenly between HY and convertible debt. Issuing straight debt was especially attractive when interest rates were low. Coupons payments were correspondingly smaller, affecting coverages ratios less and allowing the overall cost of debt servicing to be minimised. Unsurprisingly, we saw a number of corporates term out their debt without adding a convertible option, leading to the HY market growing much faster than the convertibles market.
With corporate debt increasingly costing more, we may see a trend towards issuing convertibles.
Now the boot may be the on the other foot. With corporate debt increasingly costing more, we may see a trend towards issuing convertibles. If this does occur, we expect it to supportive for active convertible bond managers. On the one hand, greater issuance means a higher total stock of convertibles – and more opportunities to exploit price dislocations. In addition, primary issuance tends to come at a discount to theoretical value. Finally, we foresee a meaningful transition period during which these relative market sizes normalise which will require a disruptive reallocation of capital within the greater credit universe. Active managers should find a bounty of profitable trading opportunities in this environment.
Conclusion
With the economic outlook more uncertain, you may be wary of testing your luck. But what is unlucky for long-only investors may well be to the benefit of convertible bond arbitrage investors. Volatility, in rates, credit spreads and equities is set to continue. Rather than making a blind bet on the direction of risk assets, if investors have capital on hand, exploiting dislocations in the convertibles market may leave them feeling luckier than ever.
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