Jupiter Asset Management’s Lee Manzi and Makeem Asif discuss the outlook for the convertible bond market heading into 2024 and why they believe the dynamics of the asset class are changing for the better.
Convertibles bonds have come through a challenging year as significant monetary tightening from central banks around the world particularly impacted small- and mid-cap share prices. Whilst a resilient labour market and stickier than expected inflation has the market believing rates will stay higher for longer, we believe an end to the hiking cycle and even sluggish growth can provide support to equity markets in 2024. Add to that the potential that convertibles can offer supportive valuations, attractive risk-adjusted returns and more diversified issuance, and this is why we believe convertibles to be appealing investments.
What does this mean for the convertible bond market?
Higher rates should be beneficial for new issuance, as corporates stand to make substantial savings on interest payments by issuing convertibles rather than straight bonds. We’ve seen some of this trend already in 2023, but more importantly we are seeing corporates issuing convertibles at much more technically attractive terms for investors. Average global coupon rates in 2023 have been in excess of 3% and premiums below 25% compared to coupons of sub 1% and premiums over 40% in 2021.
We’re also seeing a lot more sector diversification compared to the dominance of the mid cap technology names seen over the last few years. These names were hit the hardest as real interest rates rose, eroding the favourable discount rates used to value assumed high top line growth. We believe corporates will continue to buy back deep out-of-the-money bonds and replace them with new more technically attractive convertible bonds that offer better risk/reward profiles for investors. Volatility is a core component to the value of an option and low realised volatility has weighed on valuations in general. However, we believe volatility will likely increase from these low levels as the market digests the end of the monetary policy tightening cycle.
What does this mean for convertible bonds going forward?
Given the composition of the convertible universe is more aligned to small/mid cap companies, 2023 performance was more in line with the Russell 2000 (down -4.5% to end October) rather than the NASDAQ or the S&P 500, which were both driven by the performance of the Magnificent Seven US mega-caps, whilst even the equal-weighted S&P 500 was down to the end of October.
Our base case scenario for 2024 is of a soft landing, and we think anything more than a mild slowdown will result in central banks loosening monetary policy. We believe some key investment themes are interesting: sustainability will continue to be at the forefront given its importance in helping to reduce greenhouse gases. We also think semiconductors, cyber security as well as electrification will be important drivers and are well represented in the convertibles bond universe.
In terms of convertible bonds valuations, we believe the market to be attractively priced. Given volatility is historically at the lower end of the range, we think valuations are well supported and provide the potential to add value from here.
Should you have an allocation to convertibles in 2024?
Over the long-term convertibles have provided strong risk-adjusted returns resulting in improved efficient frontiers for investors. With this unique convex profile, more constructive issuance patterns we have seen and expect to see going forward and current valuations, we think the asset class offers a good opportunity for investors for 2024.