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Publication for private investors
November 2015
FocusPoint
In-depth insights from NN Investment Partners
Convertible bonds offer investors equity-like returns with a risk profile comparable to that of bonds.
Convertible bonds: the fixed-income
alternative to equities
• Convertible bonds have outperformed other asset classes in the past 40 years, profiting from equity
and bond bull markets.
• Asset class’s expected returns are comparable to equities, with lower volatility.
• Rate of default among issuers of convertibles is lower than high-yield bonds.
Convertible bonds carry risks similar to other fixed-income investments. Bonds with lower credit ratings are subject to
greater market, credit and default risk.
www.nnip.com
FocusPoint
November 2015
The fixed-income alternative to equities
Convertible bonds
Convertible bonds form a well-established asset class that has
outperformed through the cycle during the last 40 years.
Convertibles have displayed lower volatility than equities and
fewer defaults than high-yield bonds. The key attraction of the
investment class is its potential ability to generate returns from
both rising equity and credit markets.
NN Investment Partners’ convertibles investment strategy seeks
to capture the essence of the opportunities offered
by the convertible market. Our strategy is global, focused on balanced convertibles, supported by in-depth credit research and
concentrated on a select number of convertibles that combine
solid credit fundamentals, underlying equity upside and a balanced convertible profile with acceptable if not attractive valuations.
Background
The first convertible bonds were issued in the 1850s by U.S. companies seeking to finance construction of the country’s nascent
rail industry. Since then, the market for convertible bonds has
developed into a unique niche in the investment asset market, with
the value of outstanding convertibles growing to about US$380
billion as of the end of 2014. Their chief attraction – safe principal
with potentially unlimited upside – has remained fundamentally
unchanged since their conception 165 years ago.
The value of the bond at issuance can be seen as a theoretical
mix of the bond element and the option. Once issued, convertible
bonds trade in a relatively liquid secondary market (US$1.4 billion
traded daily). Prices are determined by their theoretical value and
demand/supply factors.
An explanation of convertible bonds
Historic convertible performance versus equities
Convertible bonds are corporate bonds that may be exchanged
by the holder for a fixed number of ordinary shares. They can be
regarded as a combination of a fixed income instrument and a
stock option, with the bond limiting downside risk and the option
providing equity return participation.
Convertibles are designed to increase in value alongside equities
in rising markets, while being protected from the inevitable sharp
declines. The value of the underlying bond provides a “floor” value
for convertible bonds and prevents prices falling with equities past
a certain level.
These instruments are a unique and useful tool in the investor’s
portfolio. In today’s low-yielding environment, their potential
relative return and diversification benefits make them especially
attractive in light of the lower expected returns of bonds and the
uncertainty of equities. Convertibles have historically performed
well compared with equities, with a level of volatility that makes
their efficiency, as measured by risk and return, comparable to
that of bonds. They also compete with high yield with similar
expected return/volatility characteristics. Convertible and
high-yield bonds also supplement each other with diversification
benefits. Investments in both asset classes can reduce risk and/or
improve expected returns of high yield investments. Investors who
are seeking better returns through high yield, but are concerned
about the risk involved, might consider adding convertibles.
Figure 1 shows a comparison of the performances of US investment grade bonds, high-yield bonds, convertible bonds and equities from 1973 through 1998. The 1972 values of each class have
been set at 100; their ensuing performances are tracked in relation to the 1972 base point. For example, a 1% return for a given
asset class in the first year would put it at 101 while a 5% loss
would put it at 95.
As with all corporate bonds, convertibles are subject to the risk of
default, i.e., the risk that the issuer will be unable to make timely
interest payments or repay the principle when the bond expires.
An issuer’s credit rating can give an indication of the likelihood
of default. As is the case with all fixed-income investments, the
market value of a convertible can decline when interest rates rise.
Figure 1: US asset classes’ total returns (1972 = 100)
4,000
3,500
3,000
2,500
2,000
1,500
1,000
500
0
72
74
Convertibles
76
78
S&P 500
80
82
84
86
88
90
IG Govt/Corp Bonds
92
94
96
98
HY Bonds
Source: Bloomberg, BofA Merrill Lynch Indices (1973-1998)
Equities, as measured by the S&P 500 index, were the clear driver
of growth in asset prices in this period, far ahead of all fixed
income. Convertibles still managed to follow closely, capturing
75% of equity performance.
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In the subsequent period, from 1999 through to 2014, the equity
market suffered two severe downturns and was overall a much
more volatile environment. During this time span, fixed income
performed quite well, thanks to declines in interest rates and a
limited number of corporate defaults. Convertibles were able to
benefit through their bond element and significantly outperformed
equities. Figure 2, which re-bases the values of all the asset
classes at 100 in 1998, illustrates this trend.
Credit selection supported by in-depth credit analysis
Our process is based on the belief that credit fundamentals are
essential in providing capital preservation and asymmetric
returns. We believe that these issuers with solid balance sheets
and attractive business prospects can be better singled out by
in-depth credit and business analysis than by reliance on
rating-agency notations.
Our portfolio of convertibles at the end of June 2015 consisted
of about 10% investment grade convertibles. The average credit
spread of our convertible portfolio is in line with the broader
convertible universe.
Figure 2: US asset classes’ total returns (1998 = 100)
350
300
Non-investment grade bonds have lower credit ratings and
generally pay higher yields than investment grade securities
but are subject to greater market, credit and default risk.
250
200
While the credit quality of a particular security of group of securities does not ensure the stability or safety of an overall portfolio,
we believe that a sound approach to convertible bond investing
includes limiting equity premium while selecting the convertibles
that provide the highest possible equity sensitivity in order to grab
the highest possible equity upside.
150
100
50
98 99 00 01 02 03 04 05 06 07 08 09 10 11
Convertibles
S&P 500
IG Govt/Corp Bonds
12
13
14
HY Bonds
Source: Bloomberg, BofA Merrill Lynch Indices (1998-2014)
Theme-based approach
On top of this ability to “piggy-back” on the bull markets of both
asset classes during different periods, the volatility of global
convertibles – a measure of a security’s risk – has on average
been only about 45% of that of equities.
NN IP’s convertible bond investment philosophy and
process
At NN Investment Partners, we manage an investment strategy in
convertibles that we believe captures the essence of the opportunities offered by the convertible market through an established
four-step process. In the first step we scan the investable universe
for convexity – our strategy is global and focused on balanced
convertibles. Our security selection in steps two and three is
supported by in-depth credit research and theme-based equity
selection. In step four we apply rigorous risk control in constructing the portfolio.
In order to identify the catalysts that may unlock equity value
within the investment horizon, we favour a theme-based approach
in selecting the underlying equities of our investments. A “theme”
is a set of common catalysts for underlying equities; these themes
may relate to sectors, regions or macro-economic, micro-economic,
or societal considerations. The companies that belong to a common theme are likely to react to common identified catalysts.
All our investments are selected for their fit in a chosen theme.
At any point in time, we deploy our investments into 10 to 15
themes. Figure 3 plots our theme selection in terms of weight,
equity premium and equity sensitivity at the end of January 2015.
We believe that our process, managed by an experienced
convertible team and designed after thorough analysis of the
convertible market characteristics and investors’ demands,
can optimally deliver equity participation with downside
protection and contained volatility.
Figure 3: NN IP Convertible Strategy Themes
90%
US Consumer Growth
Equity Sensitivity
80%
Real Estate Exposure
70%
60%
Online Spending Growth
Bank Deleveraging
50%
Healthcare Spending
Japan QE
Demographic Transition
Europe Rebound
40%
30%
Global Aging
Cloud Computing
20%
Oil Services Spending
10%
Cash
5%
10%
15%
20%
25%
30%
35%
Equity Risk
Source: NN IP (February 2015)
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FocusPoint
Disclaimer
The elements contained in this document have been prepared solely for the purpose
of information and do not constitute an offer, in particular a prospectus or any
invitation to treat, buy or sell any security or to participate in any trading strategy.
Investors should seek their own advice if in doubt about the suitability of any
investment. While particular attention has been paid to the contents of this
document, no guarantee, warranty or representation, express or implied, is given
to the accuracy, correctness or completeness thereof. Any information given in
this document may be subject to change or update without notice. Neither NN
Investment Partners Holdings N.V. nor any other company or unit belonging to
the NN Group, nor any of its officers, directors or employees can be held directly
or indirectly liable or responsible with respect to the information and/or
November 2015
recommendations of any kind expressed herein. Investment sustains risks.
Please note that the value of your investment may rise or fall and also that past
performance is not indicative of future results and shall in no event be deemed
as such. This document and information contained herein must not be copied,
reproduced, distributed or passed to any person at any time without our prior
written consent. Any claims arising out of or in connection with the terms and
conditions of this disclaimer are governed by Dutch law. This document is not
intended and may not be used to solicit sales of investments or subscription of
securities in countries where this is prohibited by the relevant authorities or
legislation.
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