2021 was, by all accounts, a good year for convertible bonds (“convertibles”). Despite bouts of volatility along the way, both US and global convertibles posted positive total returns last year, comfortably outpacing many other fixed income market sectors — including sovereign government bonds, as well as high-yield and investment-grade corporates.
Looking forward, we believe convertibles may continue to prove resilient, potentially benefiting from their distinctive structure amid the anticipated inflationary and rising-rate environment of 2022. Here are those three predictions for the year ahead.
Prediction 1: Convertibles to outperform both investment-grade and high-yield bonds
Since 1998, convertibles have outperformed both the Bloomberg US Aggregate Bond Index and the Bloomberg US Corporate Index in every period when interest rates rose by at least 120 basis points (Figure 1). During three said periods, convertibles even beat the S&P 500 Index.
We believe there are several reasons why convertibles have achieved these results — and why they may do so again in 2022:
- Because of their hybrid stock/bond nature, convertibles have “equity-like” features that can help drive total returns when credit spreads are tight.
- Many convertibles are issued by companies in growth-oriented sectors that have historically tended to outperform during rising-rate periods.
- Convertibles often have shorter durations than non-convertible debt securities, helping to cushion the negative impact of rising rates on their valuations.
Moreover, convertibles exhibit a trait that many other fixed income sectors lack right now: positive convexity. 1 Credit sectors like investment-grade corporates and high-yield bonds may have limited upside due to tight spreads and issuer-owned call options, along with the usual credit downside. By contrast, convertibles’ equity component can continue to appreciate in a mid- to late-cycle economy, while also retaining a bond “floor” to help mitigate potential losses.
Prediction 2: Issuance of new convertibles to be lower, but still brisk
We anticipate that the volume of convertible bond issuance in 2022 will likely be lower than in 2021, but still ahead of the average range seen during the 2012 – 2019 period.
Many upstart, tech-related companies dominated the US new issue market in 2021. Most were first-time convertible bond issuers whose equity share prices benefited from robust retail demand. We expect this issuance pattern to persist into 2022. The bottom line is that issuing convertibles is cheaper, simpler, and faster than the traditional debt-issuance process. In addition, if history is any guide, rising rates should be supportive of convertible bond issuance and supply in 2022. Finally, a recent accounting rule update 2 should attract higher-quality borrowers to enter (or reenter) the convertibles universe for funding.
Prediction 3: The global convertibles market to become “greener”
Relative to 2020, 2021 saw the volume of “labeled” convertible bond issuance — including green, social, and sustainability-linked bonds — increase in both absolute terms and as a percentage of total market issuance. Given steadily growing investor demand for such convertibles, we believe levels of “labeled” issuance (especially from European issuers) are likely to remain high in the coming months and years. As noted in our September 2021 blog post, green and sustainable-linked convertibles tend to command more favorable deal terms and to trade at a premium (“greenium”) to their non-labeled counterparts. Both are desirable features for many convertible bond issuers.
To recap, we view convertible bonds as being well positioned to help investors navigate the dual challenges of higher inflation and rising rates in 2022. Importantly, we believe the so-called “beta trade” in convertibles is more or less over. Skilled security selection will, in our judgment, be the key to success in this asset class over the next 12 months.
1Convexity is a measure of the curvature, or the degree of the curve, in the relationship between bond prices and bond yields.
2The accounting rule update referenced herein removed the previous requirement to “bifurcate” convertibles as separate equity and liability components on the borrower’s balance sheet.