Unlocking markets: The role of convertibles in uncertain times

July 04, 2023

Investors are worried about the uncertainty around recession, monetary policy and inflation. And in the face of uncertainty, investors are looking for ways to protect their portfolios.

Pierre-Henri de Monts de Savasse discusses why he thinks convertibles has a role to play in that risk mitigation and diversification movement. He also touches on why there is so much focus on convertibles at the moment covering ESG, AI and the outlook for the next 12 months.


Unlocking Markets: The role of convertibles in uncertain times - Pierre-Henri de Monts de Savasse

Host: David Horsburgh, Head of Client Solutions, RBC BlueBay Asset Management
Guest speaker: Pierre-Henri de Monts de Savasse, BlueBay Senior Portfolio Manager and Head of Convertible Bond Strategies, RBC BlueBay Asset Management
David Horsburgh 00:03
Welcome to unlocking markets and the new RBC BlueBay podcast. This is the place where we will be looking to bring you experts across the firm providing opinions on markets, global policy, sustainability, and macroeconomics, and how these feed into our investment decisions. I'm David Horsburgh Head of Client Solutions. And today I'm joined by my colleague Pierre-Henri de Monts de Savasse, Senior Portfolio Manager and Head of Convertible Bond Strategies at RBC BlueBay. Thanks for joining me today, Pierre-Henri (PH). I'm particularly glad to speak with you today as it feels like we're an environment of higher uncertainty. There is a slight paralysis in the market where sentiment shifts on pretty much a daily basis.

While a lot of conversations around investments are very stop, start at the moment convertible bonds (converts) seems to be one of the few areas where investors can engage today, without necessarily looking for a change in valuations. Why do you think that is?

Pierre-Henri de Monts de Savasse  00:52
Well, thank you very much, David, I think you are you're absolutely right. The key word here is uncertainty. Uncertainty keeps coming in discussions with market participants with investors and uncertainty about the economic scenario. Many investors think we might have a recession in the US uncertainty about monetary policy, we're not quite sure what the Fed is going to do next, and uncertainty about inflation as well, which is a very new thing. This is the first time we have had meaningful inflation in the past almost 20 years. So, uncertainty is really key. And in the face of uncertainty, investors are looking for ways to protect their portfolios, when volatility is going to rise, and this is a very strong view from our side that at some stage, it will pick up and they're looking for ways to diversify. And that's why we think converts has a role to play in that risk mitigation and diversification movement.

David Horsburgh  01:52
Thanks, PH.

I definitely see that I think when we look at the markets at the moment, you've had a lot of commentary around whether we're in a bull or a bear market, and it feels like converts is a way to keep optionality open while looking at trying to deploy risk in the current environment. Why do you think that is from a commercial perspective?

Pierre-Henri de Monts de Savasse  02:18
Yes, I think you're absolutely right. Look, especially coming at it from the equity investor perspective, you want to retain some equity exposure, you're not quite sure where the market is going to be. But at the same time, with it, there's going to be a bull or bear market or what kind of timing we're going to see. So, you want to retain some exposure, but you want to reduce risk. convertible bonds, because of this bond component, that protect equity investor against very large drawdowns are a very nice way to do that, to achieve this, maintain exposure. Don't try to time the market just mitigate risk. And, in fact, this is really appealing to a number of investors at present. We have one large investor in Australia, who has been using convert as part of their equity allocation precisely to that end, to mitigate risk in their in their portfolio. And in times of high volatility, he says worked very well for them.

David Horsburgh  03:22
In terms of markets, do you see this environment being localised within the current sort of set of macroeconomic factors that we're dealing with? Or do you think this is more of a secular shift going forward? Is this heightened volatility here to stay for at least a little while?

Pierre-Henri de Monts de Savasse  03:40
Yes, I think it's an interesting question, because many investors, many market participants think that we are changing regime when you think about it, since the global financial crisis, and you can even say since the Y2K bug of 2000, central banks have been extremely accommodative. We've been in this in this constant accommodative monetary policy with very low inflation. And all of a sudden, we have a lot of inflation, and a sense that central banks are not really on your side anymore. So obviously, there's a sense that we are changing regime, and that going forward, we're going to have more inflation, less accommodative monetary policy, and, you know, a number of challenges as well, in terms of reshoring in terms of environmental policies, in terms of trade tensions, and all this is going to add up to be on a new investment landscape. And I think convertible bonds, as I said, already, I think it's asset class, which does very well, in an uncertain world. I think they've got big role to play in portfolio diversification.

David Horsburgh  05:03
Yes, this seems like an interesting strategy for investors who have mainly been invested across the equity spectrum over the last couple of years. So, a good way to diversify that exposure through converts rather than some of the other defensive equity strategies that they might have tried to play in the past.

I know from looking at some of this, there are differences in the way that the converts universe is structured relative to some of the low volatility or defensive equity strategies, are you able to talk about that a little bit, just give us a sense of what that might be?

Pierre-Henri de Monts de Savasse  05:39
Of course, convertible bonds are a low-risk asset class, their level of risk is comparable to fixed income asset classes. This is because they've got a bond component. So as an investor, when you buy a convertible bond, your ultimate risk is a fixed income risk. If things don't go well, you're left with a bond and a claim on the company. So that mitigates your downside. And historically, it's helped investors to have a fixed income risk. However, at the same time, because you own this optionality to convert, you can participate in the equity upside, and that's where it gets attractive for equity investors. From a risk perspective, whether you are allocated to low-volatility (low-vol) equities or to convertible bonds, you're going to achieve some kind of risk mitigation, you're going to achieve a lower risk, no doubt about that.

Now, where the difference lies, is in terms of sectors, what kind of companies issue convertible bonds, as compared to low-vol equities, convertible bonds, have a bias towards high growth companies. Low-vol equities have a bias towards more defensive, high dividend paying equities, low-vol equities have done fantastically well over the past few years. And I think one reason for that is precisely because we were in this environment where interest rates would constantly go lower in a way that central banks would keep being accommodative. I think that going forward, this trend will be challenged. And I think that for the same level of risk, you would prefer to look for other asset classes. And I think that's why converts look attractive at present.

David Horsburgh  07:45
Yes, and I think this concept of the yield around converts is a really interesting one as well. Even if there are moments of weakness for equity markets, you're still getting paid this coupon associated with the bond, which I know historically has been close to 1%, or even lower. But now with the reset and rates, it's much higher, so you definitely benefit from this income positioning.

In terms of the growth environment that you just mentioned, one of the things that I don't think we could get away without mentioning is artificial intelligence (AI). And the recent excitement around that specifically around equity positioning. Is the AI theme playing on convertible bonds at the moment?

Pierre-Henri de Monts de Savasse  08:29
Yes, absolutely. The convertible bonds are a preferred instrument for fast growing companies when they need to raise capital quickly to invest. We're not quite sure, what are going to be the implications of AI in the long run over the full economy. However, it seems that we're going to have a wave of capital expenditure (capex) in the tech sector related to AI. Experts don't necessarily fully agree on the exact number, however, the proportion of data centres which are AI-ready is probably between 5% and 15%.

It's really low, those data centres need to be upgraded, which means that in terms of semiconductors, in terms of software, there will be a number of companies that will see a boom in investment revenues, of course, on the back of this AI revolution. And I think converts will naturally play their part in that capex expansion, because, as I said, for fast growing businesses, they are a quick and easy way to raise capital. And we've seen that time and again and so definitely if this capex wave comes to fruition, converts will be will benefit.

David Horsburgh  10:00
Staying on the subject around how the convertible universe is structured, I think a lot of the focus over the last couple of months has been around the US and what's happening in that equity market. And I know the convertible bond universe is global, especially the one that you look at.

Are you able to talk about how the geographical exposure is structured in the moment and where you see the biggest opportunities from a regional perspective, together with a team, we look at opportunities in convertible bonds across all regions.

Pierre-Henri de Monts de Savasse  10:36
And I think you're right, geographic diversification will be a very important theme. In the coming years, US has been such a big winner. During QE, we think that could change. You mentioned Japan, which is seeing a big revival. European equity markets have started doing a lot better as well. And all these regions are present in the global convertible bond universe. Just to give you an idea, as a rough guide, 40% of convertible bonds are issued by US issuers, around 13% by European issuers, and the rest is between Asia and Japan, so it's very well diversified geographically. And I think more and more, we'll see opportunities arising outside of the of the US. And that can also be a good argument for investors to look at converts.

David Horsburgh  11:40
Thanks, PH. I think it's a really interesting opportunity, especially from an equity mindset perspective.

One question I would have to ask is, given the hybrid nature, when you're looking at converts, where do you come at it from? Are you looking at as a bond investor or an equity investor?

Pierre-Henri de Monts de Savasse  12:00
Well, when you invest in convertible bonds, you need to have a more holistic approach, you need to look at the business, from all angles that would say, and that's what makes it really interesting. In a way, if things go really bad, and the company gets in trouble. You want to understand what's going to underpin the value of your investment, you can save on your recovery. What about intangible assets? What about actual assets? Could this business be taken over? You know, what is the core value of that business, if things really start being really bad, right? And the same time, at the other end of the spectrum, you need to think about opportunities, how this business is going to develop? Where are the growth opportunities? What is going to drive my value proposal from an equity perspective.

That makes it challenging, but also very interesting. I think most important for us is when we select a convertible investment is to avoid value traps. So, value traps would be a very safe company from a credit perspective, but with no growth prospects, so what's the point of that, you might as well buy a traditional bond. Or you can have a company, which is very exciting, which has very exciting growth prospects but maybe it's not very well managed. Maybe the asset quality is quite poor and so if things don't go as planned, you'll be massively exposed. This is the beauty in a way of investing in convertible bonds and the elements you need to consider when making investments.

David Horsburgh  13:47
It seems like you really have to basically have a mind open to all the factors effecting these businesses.

On that theme, ESG is definitely a topic that seems to be coming up more and more with both companies and investors. Is this something that plays into the converts universe and the analysis you take out on these companies?

Pierre-Henri de Monts de Savasse  14:08
Oh, yes, absolutely. I think that all market participants, and especially us, we've been focusing on sustainability, and ESG analysis. This is, I would say it's most of what we do these days when we look at businesses when we talk to management teams. It's such a key element for us and we think that it's already an element of differentiation in performance between assets. But it will be it will be increasingly so in the coming years. 2022 was interesting because I think that ESG considerations were really on the backburner, they didn't play as much of a role as in previous years, but we think this is a bit of a pause in a more profound trend. And so going forward, we think better businesses, businesses with better systemic prospects will be rewarded. And so, we continue to screen to screen for those.

David Horsburgh  15:13
And that, again, I think, is a really interesting way of looking at the universe in terms of what a go forward picture is. But before we get into that, today, the converts market has seen a bit of an uptick in issuance at the same time as other markets are maybe a little bit quieter, less IPOs, less corporate bond issuance.

I'm curious to get your thoughts on why you think that is what's driving this renewed focus from the converts market or converts to an asset class?

Pierre-Henri de Monts de Savasse  15:42
One simple answer higher rates, higher rates when rates are very low, all-in rates are very low. Companies are naturally incentivised to issue traditional straight debt, because they pay very low coupons, so why bother in a way. Obviously, interest rates have risen significantly, enormously, which means that some businesses, even very high-quality businesses, very high credit quality businesses are facing much higher interest rate costs and that impacts the profitability. And so, CFOs are incentivised to look for other ways, other means of financing with lower coupons, and convert it exactly that.

As an investor, when you buy a convert from a company, you're giving away a bit of coupon, and in exchange, you're getting an equity optionality, so this is a very attractive environment, both for companies to issue, but also for investors. Because if you're ready to give up that bit of control, you can get very attractive upside optionality. And we think this is going to be a big driver of performance for the asset class in the in the in the coming years, a pickup in the primary market.

David Horsburgh  17:07
Based on the activity you're seeing in markets today, what does that do to your outlook for the asset class going forward over the next 12 months to maybe even further out to three years?

Pierre-Henri de Monts de Savasse  17:20
It's difficult, as we explained earlier, taking a view on the direction of markets is really hard, I think converts will outperform other asset classes. Because, as I said, we'll see primary market issuance, which historically has always been a boost to performance, because we will see flows from equity investors, trying to reduce their risk and diversify their portfolios. I think also, we might see fixed income investors, trying to avoid long duration assets and volatility on interest rates. And I think also that the convertible bonds the optionality embedded in convertible bonds, is generally cheap. We had this big market dislocation at the beginning of 2022. It created what I would call a deep value opportunity for converts and the asset class as only started rerating, so we see 2023 as a beginning of renewal cycle, in terms of valuation for convertible bonds.

David Horsburgh  18:32
Thanks, I think, you know, we've discussed we've covered quite a lot of the universe at the moment. And I think it sounds like a really interesting opportunity, especially from all angles, depending on whether you're coming from it from an equity or fixed income perspective. Thank you for your thoughts on that.

Finally, I just wanted to ask a question. It's an asset class that I think a lot of clients are unfamiliar with. But it's probably a more curious question around how did you actually get into the asset class in the first place? Did you come from the equity side or the fixed income side? Or did you come from a third option entirely?

Pierre-Henri de Monts de Savasse  19:13
I'm coming from the from the risk side, my background is in pricing derivatives and, and also fixed income derivatives as a matter of fact, and I was managing risk in previous jobs. And because the class has a fairly strong quant component and derivatives component in pricing optionality, of course, and that's how I came to manage convertible bonds. That's an interesting question, I think they are quite a few of us in the same way in the same position, we started looking at derivatives and came to the asset class afterwards.

David Horsburgh  19:56
So, you don't need to be a quant to that invest in convertible bonds, but it sounds like it helps!

Pierre-Henri de Monts de Savasse  20:02
I think the thing about convertible bonds is that you can be a former equity investor, you can come at it from a credit investor, you can come at it from a more from a risk perspective, maybe which is more my background. It's a challenge of course, there are many moving parts, but there are also so many angles, so many opportunities, so it's very dynamic. It's moving a lot. But, yes, I enjoy.

David Horsburgh  20:31
Thanks, Pierre. Henri. That was an incredibly enlightening discussion. I think we managed to cover a lot over a fairly short amount of time, and hopefully we've given people some thoughts around a different way of tackling their equity market exposure today. I really appreciate your thoughts and your time, and I hope we'll get a chance to do this again at some point. If you're enjoying the show, please like and subscribe on your podcast platform of choice. Good luck and goodbye. Thank you very much.

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