WHERE DOES IT GO?
Where to put it is a concern, too, says Drewienkiewicz. Larger consultants say your multi-credit/equity manager should look at it, but with coupons of between zero and 0.25%, it isn’t an income asset, he says. So it might go in the fixed income allocation, but that will be something of a fudge. “We feel we have a lot of tools in our toolbox already,” says Drewienkiewicz.
Some large institutions have struggled, such as the Chilean pension fund and some European schemes, to treat CBs as a separate asset class, says Perrin. Some have used them to balance the ocket they are in while others have treated them as structured products, which he says is plain wrong.
Others use them as a booster to bond allocations or a dampener on equity allocation. Wherever you allocate them doesn’t matter, he says, provided you understand what you are trying to get from them. “If looking for a boost, don’t be surprised if the boost is very low. The same with equity – it does not always match the MSCI World.”
How they are used depends on each individual portfolio, says Saber, but often CBs are “treated like an orphan child”. Some use them strategically, others tactically. Others are scared and looking for opportunities everywhere.
Historically, CBs have the best risk-adjusted return, so why not include between three and 10% in the mix, asks Saber. If there is one thing that is guaranteed, that is volatility,” he says, “and we are advocating convertibles. “We don’t know where it will go, but the sweet spot is having convertible bonds there.”
WAKING UP TO THE POSSIBILITIES
Consultants have seen richer pickings elsewhere in the past, says Saber but they are starting to accept CBs and recognise it is something they should be looking at. Some pension funds like the performance and the volatility control, but have to get their heads round the coupon differential on an annual basis. If they don’t trust the equity return, they should stick with bonds, but if they believe equities can perform well, why not go with convertibles?
There is a lot of interest in CBs from the wealth management and family office market, says Saber. This is another reason for many institutional investors to stay away, Drewienkiewicz feels.
“We are not wild on asset classes with high high net worth or retail penetration,” he says. “European money is more flighty than you might expect and if pushed into these classes by advisers, things are fine while the asset class is increasing, but when it displays downside volatility you see where the asset class tourists are and they all go home.”
That said, the pressures of Solvency II have forced insurance companies in Europe – in particular Germany, France and Switzerland – to take an in interest in convertibles. “Bonds are seen as a nice way of minimising portions of risk on your balance sheet,” says Perrin.
“Insurance companies are interested in convertible bonds to add equity risk without the need to provide for equities. Pension funds who can’t allocate as much to equities due to their LDI strategy may also find them useful for this reason.”
“Convertible bonds – especially unrated convertible bonds – are very favourably treated under Solvency II,” says Saber. “Some say CBs are a bear market instrument, but this is rubbish. They were even good in 2013.” The market for CBs has not been good since January, but the volatility on the horizon is going to make everything look a little painful before long.
Perrin understands the reluctance from large institutions as the CB market is relativelysmall at $450bn, while the markets for bonds and equities are almost endless. But convertibles can be managed with the use of synthetics and no-one expects CBs to take the world by storm. “Insurance companies won’t have 25% of their portfolio in convertible bonds, but will always be used as a side pocket,” he says.
The questions any investor must ask, he says, are: is the market good enough; is there enough diversity; is there sufficient credit quality; is it expensive? Saber rejects any notion of it being expensive, suggesting those looking at beta strategies are perhaps paying more than they need to.
He uses best ideas to create themes in a restricted universe and this offers good value and protection, he says. “Convertibles have a place on the bond or equity allocation of actively managed balance sheets of any institution,” he says.
“It’s an easy way of adjusting risk of any market you are looking at and better than high yield over the last five years.”
