Inflation is back and could spell the end of ultra-expansive monetary policy. Convertible bonds perform exceptionally well in market phases like these.
Consumer price indices have been rising worldwide for several months. This is attributable in part to temporary effects such as logistics bottlenecks. There are also signs that inflation may be making a permanent comeback, or perhaps that the global economy is heading toward decarbonization, or that global supply chains are having to be realigned on the back of current geopolitical tensions and the pandemic.
A new phase on the financial markets
In spite of the war in Ukraine, observers in the US are anticipating multiple interest rate hikes this year. Investors have already accepted the new reality and have exited from government bonds, causing their yields to skyrocket. Growth stocks are bearing the brunt on the equity markets with their future profits being assessed today as being lower. But what about convertible bonds? In their basic variant, they consist of a bond with an option for conversion into a specific number of shares.
Convertible bonds have the potential to bring surprises
Given their hybrid nature, it is not immediately clear how convertible bonds will behave in an environment of rising interest rates. We took a look back at years past and explored how these instruments have performed in times of rising interest rates since the introduction of the Refinitiv Convertible Bond Indices on January 1, 1994.
There were ten periods during this time when 10-year US government bonds put on more than one percent. We also included the most recent phase, even though the current hike in yields amounts to just 0.55 percent. It is hardly surprising that the global bond index, which consists primarily of government bonds and investment-grade corporate bonds, performed rather poorly during these periods, since lower credit risk premiums were in most cases unable to offset the rise in interest rates. Convertible bonds, by contrast, surprised to the upside, recording gains averaging 9.5 percent in nine out of eleven periods – almost achieving the performance of global equities. The main reasons for this are likely the lower duration of convertible bonds compared with other fixed-income instruments, and the similarities convertible bonds share with equities. The high equity participation of over 90 percent is attributable to various factors, for example favorable momentum on the primary market, or particularly high variation in performance of the underlying equities in phases like these. This, combined with the asymmetrical risk profile of convertible bonds, provides a favorable starting position. In the current rising interest rate environment, however, this has yet to transpire. This is chiefly due to the upheavals on the financial markets in the wake of the war in Ukraine, coupled with the high weighting of convertible bonds given to the growth-oriented technology sector. This offers an entry opportunity at a lower level. So there are two good reasons to invest: an empirically positive correlation between rising interest rates and the performance of the asset class, and lower entry prices compared with the fourth quarter of 2021.
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