Stability in volatility with convertible bonds

Arnaud Brillois, Managing Director and Portfolio
Manager/Analyst on the Lazard Global Convertibles team

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Arnaud Brillois, Managing Director and Portfolio Manager/Analyst on the Lazard Global Convertibles team, shares his knowledge on convertible bonds and how they differ from vanilla equity or debt. Learn about the benefits of convexity, and how you can protect your investment portfolio from volatility.


Transcript

Paul O'Connor:

Welcome to the Netwealth Investment podcast series. My name is POC: and I'm the Head of Investment Management And Research. Today, we welcome Arnaud Brillois from Lazard Asset Management, who is a Managing Director and Portfolio Manager and Analyst on the Global Convertibles team. Lazard was established in 1953 and was privately owned until listing on the New York Stock Exchange in 2005. Lazard is a major global investment manager with almost 300 billion AUD in assets under management invested across a range of global, regional and country specific strategies, both traditional and alternative in listed equity and fixed income. The firm now operates from 24 cities across 17 countries and has over 800 staff globally. Arnaud began working in the investment industry in 2000 and joined Lazard Freres Gestion, in 2008 and was Head of Convertible Bonds and Co-head of Alternative and Structured Products before relocating to New York with Lazard Asset Management, in 2017. Prior to joining Lazard, he was the Director of Alpha Bonds and Convertible Bonds Management at Natixis Asset Management.

POC:

Arnaud is a graduate of the ISCID and is a CFA Charterholder and a member of the French Society of Financial Analysts.

POC:

The Lazard Global Convertible Bond Fund, is an actively managed convertible bond portfolio that typically holds between 60 and 80 convertible global bonds that are selected from a universe of approximately a thousand securities. The investment team employs a fundamental bottom up approach that utilises rigorous qualitative and quantitative analysis to drive security selection, complimented by a top-down process that guides tactical positioning across the portfolio. Given Arnaud’s role is on global convertible debt, we'll focus today's podcast on convertible bonds including, what are they? What are the risks and how they can be used in a diversified portfolio?

POC:

Convertible bonds are a hybrid type security that are issued as a bond, but can be converted to equity or shares, but we will allow Arnaud to elaborate. It'll also be interesting to understand how convertible bonds performed during 2020 and what's the outlook for issuance in the market. During 2020, interest rates continued to fall. So the other point to discuss today is whether convertible bonds can play a role in providing reliable income into a portfolio and can they be an alternative to traditional bonds?

POC:

So welcome to the Netwealth Investment podcast, Arnaud, and I hope that you and the Lazard Global Convertible Bond team are all well. But has your workplace returned to any pre-COVID normality and is the team all back in the office during the week?

Arnaud Brillois:

Hello, Paul and hello everybody. I'm very happy to talk with you today. In fact, in New York, only 10% of workers are back to the office, but in my team, it's very close to be back to normal. 80% of my team is coming back to the office on a daily basis. So little by little, that's why I'm so optimistic, because little by little we are coming back to normal and everybody's safe.

POC:

Ah, that's great to hear. I know we're slowly readjusting and moving back to normality or whatever that will look like in Australia now. So it will be interesting, but I think the workplace has changed permanently in terms of the working from home and working from the office balance there, so... Moving into the podcast and the topic of the podcast. And before we get into convertible bonds, what's your view and your thought on the outlook for the global economy in 2021? What concerns you the most about the year ahead? Perhaps is it interest rate rises driven by inflation or for the COVID related problems, continuing to slow the global economy or even geopolitical risks on the horizon?

AB:

Oh, so I'm going to talk a little about equity, credit, interest rate, because there are some constituent part of the convertible bond. So I would say that we remain positive and optimistic on the performance of equity markets in 2021. In fact, we believe that equity market will be supported by the first signs of a return to normalcy as vaccine are being rolled out and consumers starts unlocking the vast amount of savings accumulated during the crisis. Between the U S and Europe, we do not anticipate a significant high performance of foreign region and against the other, as the high level of innovation and growth in the U S will be matched by a recovery from higher evaluation discounts in Europe. However, from a sectorial perspective, we anticipate high level of rotations between technology and retail sectors, for example. It will necessitate an active allocation and positioning on a sectorial basis.

AB:

And for credit, we anticipate that credit markets remain supported by a recovery of the equity markets. In particular, in the context of strong liquidity and financial support provided by accommodative central banks across regions. While interest rate, like you mentioned it, has been trending higher across regions in 2021, so far, it should be put back into perspective, as for example, the U S interest rates are just back at the pre-COVID levels and already low level of interest rates historically. Eventually we anticipate stronger intervention from central banks, should interest rates continue rising. This is particular true in the context of global inflation that remained subdued and still well below the targeted levels of American and European central banks.

POC:

Yeah, it has been interesting. I mean the whole issue of interest rate rises. So we've all noted the rise in the 10 year bond yield in the U S and also in Australia. So do you see the longer term dated bonds continuing to trend up the yield on them?

AB:

I think that the central banks will let the interest rates to go up till a given level. For example, the Fed has not only to be careful about inflation, but they have to be careful about employment. And unemployment, it will still very high. The cost of refinancing is going to become higher and higher, and will decrease the potential refinancing credit of a company. So we believe that it's going to continue to go up, but for example, for tenure of the US, at one point, it will rise around 1.90% or 2%, suddenly the Fed will start to change its stage and it's way of seeing interest rate and may intervene, in order to keep it at a lower rate to be sure that it's won't impact a part of the economy. So at the short term, yes, I believe that it's going to still go up, but at some point it will stop, though.

POC:

Yes, well, I guess it's positive overall. The fact that we're getting more of a normalisation of the yield curve there, Arnaud but... We'll get into the convertible bonds anyway. So for the benefit of some of the listeners, could you explain what is a convertible bond and perhaps give just a couple of comments about the history, such as how long have these securities been issued by companies?

AB:

Oh, Paul, don't worry. I'm now doing to give you all the story of convertible bonds. Because in fact, many investors have the belief that it is very fresh, it is very new, but in fact, convertible bonds have a long history. They were created back in the Middle Age in Italy, by the Medici. And later they have been used as a financing tool by the U S barons during the Industrial Revolution. They did a come back in the 80s and have since then grown in popularity.

AB:

To explain how a convertible bond is working, first I would say that it is a simple and standardised product. First and foremost, it is a bond. So it has maturity, it has a coupon, it has reinvestment at maturity, all organised in a normal prospectus. But there is something extra in the prospectus, the holders can convert into stock at a predetermined price. It is called[inaudible 00:00:10:22] type. So if underlying equity has been rising, it will be more interesting to convert to realise a profit. And if underlying equity has been falling, then we will ask to get back the cash and we will add all the coupons and the yield to maturities.

POC:

So how does a convertible bond differ from vanilla equity or debt and other simply debt securities, and do they convert to equity?

AB:

In fact, convertible bonds have sensitivity to a much broader range of factors when valuing the equity of it. Compared to equities, they are both sensitive to the equity price, of course, but convertible bonds will also have sensitivity to the equity activity. The more equity are volatile, the more the option, including the convertible bond is valuable. Compared to vanilla debt, they will also have sensitivity to credit spots and interest rates, but with an average modified duration that is quite low, around two. The convertible bond market is usually less sensitive to increased interest rates by the credit markets. Also convertible bond can benefit from specific clauses. For example, the Frequent Clause in the prospectus is called Takeover Protection. It will provide an extra return for convertible bonds holders, should the company is the target of a takeover bid.

POC:

It's interesting there. As you're talking Arnaud, I'm just thinking to myself, so to be an analyst and a portfolio manager of a convertible bond portfolio, you've almost got to both be an equity analyst and have equity analytical skills, but also have the traditional credit analysis skills there. So it must be a fairly dynamic part of the market to study and to try and value there. So it'd be interesting, the type of staff and the background that you employ in your team to be able to support that.

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POC:

Most investors are positioning their portfolios to have a minimal exposure to duration. So as convertible bonds are typically low duration instruments, how does the duration compare to say, the high yield market or credit securities?

AB:

Convertible bonds modified duration is structurally low, around two. And convertible bonds have typically very well reacted to the amount of rising interest rates. Because most of the time when you have rising interest rates, you have rising equity markets. So the equity part of the convertible bond is going to compensate for the impact of rising interest. Since 1989, there has been nine years where the U S ten-year rates have risen. And out of these nine years, eight years, the convertible bond market produced positive returns. So indeed, the convertible bonds do very well during rising interest rates.

POC:

Something unique to convertible bonds is convexity. So can you explain convexity and what are the benefits for investors?

AB:

Convexity is the magic word of the conventional bond universe. So in fact, the structure with convertible bonds creates a very specific payoff profile. When equity prices are rising, convertible bonds are capturing more and more of the upside allowing them to participate greatly to the upside of equities. And when equity prices are falling, convertible bonds become less and less sensitive to work with the prices, as well bond components creates a cushion. These characteristics makes the pay off of convertible bonds very convex, in particular during volatile markets

POC:

So what attributes are you looking for in a great convertible bond, and how was your approach similar or different to what an equity or a bond investor might do?

AB:

In fact, first, we want to make sure that the credit is sustainable to avoid any defaults. The convertible bond is a bond, so you have to focus first on the credit side. Second, we want to make sure that there is high upside potential on vendor and equity to be able to provide strong, positive returns. Third, we use quantitative analysis to make sure that the convertible bonds offer the quantitative aspects that we are looking for, such as high convexity. Here, it is the interest in the asset class, but it necessitates the questions monitoring because of the clauses in the prospectus and all the corporate actions that they have during their life.

POC:

So it sounds to me that the analysis begins with looking at the bond, like a traditional fixed income security. And can the company pay the coupon? Can we get my capital back? But then I guess, when you're looking at the upside, you're thinking more like an equity analyst, in terms of the optionality and the convexity you explained earlier on.

AB:

You're totally right. And that's very funny that you express that part and the fact that you have to have a complete view for when issuer, not only the equity part, but on the credit part and the volatility of the entire equity and the clauses, because that's why I decided to manage convertible bond 20 years ago. Because it was on that side that was giving me a broad view on one company and on the global financial markets

POC:

To understand the issuer risk in a little more detail, what type of companies issue convertible bonds? And is there a bias potentially to the high yield sector or with sub investment grade credit ratings or the higher quality companies from an investment grade perspective, also issue convertible bonds?

AB:

In fact, convertible pants are mostly issued by mid-caps and growth companies, in particular, in the technology and communication sectors. This means that they'd benefit from the changes of conceptions patterns that have emerged in 2020, while offering a dynamic growth profile by the smaller capitalization. This company typically issue only convertible bonds, and therefore do not have a need to have rating agencies providing rating. As a consequence, more than 60% of the convertible bonds in our market are non-rated. We also have many convertible bonds in other space that are in sectors that have suffered from the COVID-19 the crisis, such as issuer linked to tourism, airlines, transportation, events. These companies are particularly cheap as of now and offer good upside, in our view.

POC:

So in terms of the credit risk, then if a lot of the companies don't have ratings from credit rating agencies, does your investment team undertake a shadow credit rating analysis of the inherent credit risk in a convertible bond?

AB:

We have to ask a lot of non-rated convertible bond, we have to do a specific study of credit. Then we have to create some internal credit rating, just to monitor the credit risk in our global portfolios. So we are doing the normal credit analysis. And in virtue of market, as we are focusing a lot on the recovery companies, we have been incorporating new rules. For example, we are not investing in companies that have less than 14 month, one four months of cash at the current cash burning rate. So credit is very, very important. And I joined Lazard back in 2008, and we never had any defaults in the portfolio. We believe that we have to be conservative in the credit to have a strong protection with the bond component of a convertible bond, especially when you have some equity exposure in the convertible.

POC:

Yes. Well, I guess 2008 would have tested your credit analysis there. It seems like that was a good result there, that you didn't have any defaults in terms of the coupon payments of the bonds you held in your portfolios through that period. So how big is the convertible bond market globally? And can you actually build a portfolio appropriately diversified by issuer, by country, by industry?

AB:

Thank you. That's a very interesting question. In fact, the convertible bond market total value is now above US$ a 500 billion. It has increased by more than 50%, since the end of 2019. 2020 has been marked by a very strong primary market. This is in fact a direct consequence of what we call, Level Of New Issuances that we have observed a since COVID started, as well as the overall market appreciation, following the strong returns over the past year. Convertible bonds have always had some biases towards the of growth companies, sometimes towards recovering companies, but on the global market, it is always possible to find exactly what you want in the portfolio, in terms of sectors, in terms of protection, in terms of complexities. So yes, currently the convertible bond market is very well diversified.

POC:

Well, that would give me confidence there, that as an active manager, you'd be able to appropriately move the portfolio around and highlight different industries, and countries and some other trends that you were trying to capture also in the portfolios. So probably not dissimilar to an active equity manager or a credit manager, I guess. How does the strategy perform when markets are volatile? And perhaps, can you explain how the strategy went through the global financial crisis or even more recently in March 2020, when we saw extreme equity market volatility as markets were sold off heavily?

AB:

In 2020, convertible bonds market did not disappoint. As the sale off started from the end of February to mid-March, convertible bonds became more and more defensive and show lower holdings than equities and high yield bonds. At the beginning of 2020, convertible bonds were very convex, and as a consequence, were protected with the bond component. But when the rebound started in late March, convertible bonds quickly became more and more sensitive to equity prices in capture of the rebound, maintaining a considerable out-performance relative to the global equities.

AB:

As a consequence, our convertible bond index returned a plus 25.4% in 2020 in U S dollar returns, greatly outperforming global equities, global high yield. Our strategy did even better. We returned 39,32% in 2020 yield to our investors. This is explained by the convexity of the assets, that makes the asset becoming defensive when the markets are falling, and capture the upside, when markets are rising. Our performance is explained by 75% by our bond selection, the right company, the right sectors in a good part of the world, and 20 to 25% is explained by effect of dollar, the bigger exposure of our portfolio as well in equity, as in modified ration or in credit risk.

POC:

So many retail Australian investors will be aware of the Australian Stock Exchange listed bank hybrid securities, which are a form of a convertible bond, but a key drawback with those securities is that the issuer has the right to convert the bond to where equity is subject to trigger events. The equity conversion, as you've mentioned, has embedded option value, which I guess from the holder's point of view might be positive where the option is exercisable by the holder or negative where the option is exercisable by the issuer. And this is where, I guess, Australian issued bank hybrid securities have divided many investors. As a result, quite a number have shun these securities because of the perceived negative option value. How do convertible bonds or the type of bonds that you purchase in your portfolio differ from the Australian bank hybrid securities?

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AB:

Indeed, they are completely different products. First, bank hybrids are issued by banks, while this a very small sector in the convertible bond universe. So going on, most importantly, they have a difference such a convertible bond is basically a bond and the call option. So if the underlying equity rise, the convertible bond will rise too. It also means that the convertible bond holder is not forced to convert into stock, it is a choice. When the convention happens, it is usually a good news. With a bank hybrid, an increase in stock price as limited impact. And the choice, like you mentioned, to convert, is not with the investor. It will be forced on the investor if there is a problem with the bank.

POC:

So you're just reinforcing the perceived negative option value in an Australian listed bank hybrid. And whenever you do look through the terms of the bank hybrids, the conversion terms, they're extremely complex. And my takeout has been that the conversion would occur when the equity is falling in value and not rising in value, so hence that negative option value. So I guess it's interesting your comments there. You're focused very much where the option is exercisable by the holder of the bond, as opposed to the bank hybrid structure there.

POC:

How can convertible bonds be used in a diversified portfolio? Do you believe they enhance portfolio diversification? Given that we're looking at security that has bond and fixed interests like characteristics, but can become equity, it can be a little more of a challenge for investors to work out how to position these in their portfolios.

AB:

In fact, the convertible bond has a very strong diversification power. First, they have a performance that is close to global equities with about 30% less volatility over the last five years and 10 years. With such a risky world profile, it clearly improves a very efficient frontier of a diversified portfolio. In particular, because correlations are quite low versus the over asset class or very different. For example, if the correlation of multiple bond with equity will be high, it will be smaller but positive with interest rates and it will be moderate with credit risk. So adding 10% of convertible bonds in a diversified portfolio allows to increase returns and to lower risk.

POC:

Yes. Well, the key point that has come through in my mind from your comments are now is that yes, whilst they are a fixed interest like security and they can be behaving like an equity, they do not trade in line with the movement of the fixed interest market or the equity market. Hence, at a high level, it does occur to me that they've got to add diversification in a portfolio just by having an exposure potentially of 10% as you mentioned there. So yeah, I can certainly appreciate the benefits to portfolio diversification from using a convertible bond strategy in a portfolio. So finally, is now a good time to invest in convertible bonds based on the assumption, interest rates can't go much lower and hence we're hoping they must start to rise or continue to rise? What's your outlook then as a result for the convertible bond market?

AB:

Looking forward, we have a very positive outlook for equities, and equity is a large part of the performance of convertible bond. And that outlook, the positive outlook is very strong for the companies still in the recovery phase, what often present attractive evaluations. Recently issued, these bonds offer the opportunity to participate in the potential recovery while being protected by the defensive aspects of the convertible bond structure. We think the company that have benefited from the lockdown, such as E-commerce, Cloud computing or internet security. We focus on the companies that we believe will be able to maintain a high revenue growth momentum, and continue to surprise positively in the next two to quarterly release. After of that our selection, we think that technology sectors will be in a role with a very unique evaluation basis. As a convertible bond, we already talked about the creditors, a few words on the credit perspective. We are so observe a very virtuous cycle since the recovery made.

AB:

While a strength of underlying equity will bring significant credit tightening ideal to the potential returns of these convertible bonds, we tend to focus on issuers with the most resilient balance sheet and we anticipate another wave of refinancing in the coming quarter, which will create potential opportunities. Conversely, if a situation was to deteriorate, convertible bonds have historically exhibited 45% less default rates than traditional high yield corporate bonds. From the perspective of interest rates we believe and we already talked a little about it, that they'll remain low in the near term as the central banks across regions have adopted very accommodative monetary stances in order to contain the economic dynamic fall out from the Coronavirus outbreak. In any case, convertible bonds are not particularly sensitive to interest rates with modified duration that is around two, in average.

AB:

These factors combines in a positive outlook for preventable bonds during the first half of 2021. Driven by the continual recovery of the consumers and tourism sectors as well as solid performance of specific sub-sectors of the technology sector and an overall high level of convexity for the record of new issue. We anticipate that new issue volume will remain elevated in 2021, especially during the second half when companies will need to refinance high level of maturities and may require additional financing.

AB:

This may create some pressure on the evaluation of a market, even thought it is currently at relatively cheap levels. But we believe this would be balanced by the benefits of increased issuer diversification and higher convexity to the market. So we stay very optimistic on the asset class and in our capacity of invective of our active management, to be able to follow the different rotation and the different movements that we will see in the market in the next month.

POC:

Arnaud, thank you very much for joining us on the Netwealth Investment podcast series, this morning. I've certainly found it very educational. Your comments, your thoughts, your insights into the convertible bond market. I do know that we currently don't have the Lazard Global Convertible Bond Fund on our investment menu, but I'm sure it's something we could arrange, if any listener was interested in investing in the strategy. And I'm sure it's something that I'm happy to have further discussions with Lazard about there. But it's certainly an investment strategy I know where there aren't a lot of standalone, convertible bond strategies available in the Australian wealth management market. So I certainly wish you all the best for the fund. And as I say, I think it's come across very clear that considering the use of convertible bonds in a portfolio can certainly improve the diversification benefits in the portfolio there.

POC:

So again, thank you very much for joining us this morning. I know we very much appreciate your time and your insights. To the listener, thank you again for joining us on the Netwealth Investment podcast series. I certainly hope you enjoyed the session this morning with Arnaud Brillois, from Lazard Asset Management. And I wish you all the best to have a great week ahead. Thanks for joining us.

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