By Simon Miller
Convertible bonds have become an appealing, more mainstream asset class according to Fitch Ratings.
The agency said that although global CBs have almost matched global equity with returns around an annualised 9.5% over the past three years, with 50% of the volatility, there were still investment and technical risks that fund investors need to be aware of.
In two reports published today, Fitch notes that over the past three years, CB funds have captured more of the market downside and less of the market upside than expected, according to it's research, which may point to greater credit sensitivity, notably in high yield.
The asymmetric return profile, or CB funds' ability to capture equity upside and protect against equity price falls, claimed by the industry is overstated for certain funds, Fitch has found.
Lower CB issuance has led to a stagnating market, while long-only "buy-and-hold" institutional investors have generally replaced hedge funds as convertible bond holders since the collapse of Lehman. This has resulted in less liquidity and more mispricing on certain segments of the market.
"Fund investors need to focus on four areas when selecting and monitoring a CB fund: yield, convexity (ability to generate asymmetric returns) and overall risk profile; management of liquidity and supply constraints; management of market sensitivities and the ability to draw on multiple resources and inputs," says Manuel Arrive, senior director in Fitch's Fund and Asset Manager rating group.
A reduction in the amount of CBs available for investment, currently around €400bn (£324bn) globally, resulting from lower issuance is becoming a concern, particularly in Europe. Capacity and concentration are two risks that investors need to be aware of in this context.
Yield and convexity are two characteristics of CB that make them attractive in the current market and that asset managers focus on in their bottom up analysis. In Fitch's opinion, yield analysis relative to credit quality requires strong credit skills, notably as high yield, unrated and small caps names are growing in importance in the CB universe.
Fitch added that maintaining convexity also required discipline in portfolio selection. While bottom-up analysis is the essence of CB investing, in Fitch's opinion, certain funds could gain from a more tactical, dynamic management of delta with a short-term investment horizon.
Global CB funds have seen net inflows of over €2bn year to date, offsetting outflows from European funds (over €600m). Overall, convertible bond fund AUM has stabilised above pre-Lehman levels at €55bn.