For more than a year investors have been taking money out of global convertible funds after loading up the prior 2 1/2 years. A few of those who pulled out money could be having regrets, given that this asset class rebounded to higher levels after the turmoil in the bond and equities markets earlier this year and again in the aftermath of Brexit.
The Bank of America Merrill Lynch G300 Index of global convertibles fell 6.8% from the beginning of the year through Feb. 11 before bouncing back into the black with a 3.6% gain as of June 23, the day of the Brexit vote.
The index then fell 2.5% the following day, and then moved up again to reach a level on July 14 that represented a 4.3% gain from beginning of the year.
This year’s performance demonstrates one of the hallmarks of global convertibles – their ability to buffer market moves. A look back over the last 10 years, the volatility of the G300 index, as measured by the standard deviation in monthly returns, is lower than the volatility for the MSCI All World Equities Index.
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“Convertibles are an all-weather instrument,” says Stefan Schauer, Frankfurt, Germany-based senior portfolio manager at the Deutsche Global Convertibles Fund, which has £175.8 million ($229.3) in assets under management with a 10-year annualized return of 5.9%.
The all-weather performance of this asset class is one reason why AUM for global convertibles has risen to $290 billion worldwide with $175 billion in the U.S., $73 billion in Europe, $17 billion in Asia (excluding Japan) and $25 billion in Japan, according to Michael Youngworth, convertibles strategist at Bank of America Merrill Lynch.
“Since convertibles are not perfectly correlated with either stocks or bonds, their addition to a portfolio can dampen overall volatility,” he says.
In addition to the coupon, convertibles offer the option for investors to convert the debt to equity typically at a set ratio of shares per bond. This offers the benefit of potentially strong gains when equity prices rise but modest losses when equities fall, in part because convertibles come with a coupon rate that provides a stream of income to investors, according to Youngworth.
Fixed-income yields may feel low, but foreign investors facing negative yields at home are making the U.S. markets popular.
Despite the strong AUM, there has been a recent outflow in this asset class after months of inflows. The recent turnaround in fund flows started in the third quarter of 2015, according to data tracked by eVestment. From the first quarter of 2013 through the second quarter of 2015, investors made $9.7 billion net new allocations to global convertibles in 59 global convertible funds tracked by eVestment. In the last three quarters ending March 31, 2016, $6.2 billion has flowed out of global convertibles. Thus, two-thirds of the global inflows over 10 quarters flowed out in the following three.
Investors have exited in part because yields fell to 1.8% as of July 13 from 2% on Jan. 1. “Investors are a little freaked out about what to do with their bond portfolios with rates as low as they are,” says Eli Pars, co-chief investment officer at Calamos Investments. “People are concerned about downside risk in what should be the safer part of the portfolio,” he adds. The Calamos Global Convertible Fund has $75.1 million in assets under management.
“Historically, convertibles have done well in a rising interest rate market,” says Eli Pars, co-chief investment officer at Calamos Investments.
The lower current yields are tied to the rising values for global convertibles. “Increased equity volatility is a positive for the embedded call option within the convert, which improves its valuation,” says Youngworth. As valuations for convertibles rise, it can lead to a decline in yields. Conversely, the prospect of higher interest rates from the Fed would be a positive for convertibles. “Historically, convertibles have done well in a rising interest rate market,” says Pars.
Global convertibles are "the cheapest they’ve been on a top down view since the financial crisis,” says Shawn Mato, senior portfolio manager at Westwood Holdings Group in Framingham, Mass. "So there’s a lot of opportunity to go out and buy cheap convertibles,” Mato says. Westwood launched a couple of global convertible funds under its brand in May 2015, and the firm is sub-delegation manager of the $195 million Aviva Investors Global Convertibles Absolute Return Fund, which had an annualized return of 2.9% over the last five years ending July 13, according to Morningstar.
Not only are prices cheap compared to historical measures. There are other benefits as well. “More broadly, we think converts offer a nice middle ground for investors who are uncertain about the direction of the market going forward amid a myriad of risks, including the timing of any Fed rate hikes and the U.S. election, just to name a few,” Youngworth says.
