Performance Update – Unexpectedly Unspectacular

Every region is grappling with its own problems, some of which are self-inflicted, and these issues not only affect the respective regions but also interact with the challenges of other regions, often exacerbating the situation. 

• In the U.S., concerns dominate over whether the Federal Reserve will manage to get inflation under control and guide the economy to a soft landing without slipping into a recession.
• China continues to struggle with the effects of its strict zero-COVID policy, which is increasingly negatively impacting both national and global economic growth. The supply chain bottlenecks are only being worsened by this.
• Europe is economically the hardest hit by the ongoing war in Ukraine (sanctions, higher energy and food prices, expropriations, and loss of markets, etc.), and like the U.S., Europe is also dealing with the highest inflation rates in decades, but without the same leeway in monetary and fiscal policy.

All these factors contribute to a multitude of uncertainties and have resulted in the "worry barometer" rising rather than falling after nearly two years of COVID measures in Europe and the U.S. This is also reflected in the financial markets, which have been shaken considerably since the beginning of the year, with hardly any asset class escaping the turmoil.

Stock markets have mostly lost value in the double-digit percentage range, with growth stocks experiencing larger setbacks than value stocks. As interest rates rose, bond markets also declined sharply, and credit spreads, especially in the sub-investment grade sector, widened noticeably. The correlation between stocks and bonds was positive, which reduced the risk diversification of investor portfolios. The U.S. dollar appreciated against most currencies, and commodities saw clear gains. Gold (in USD) remained relatively stable, while cryptocurrencies suffered significant losses (e.g., Bitcoin by nearly -40%).

Change Since the Beginning of the Year (in Local Currency)

Considering the performance of various asset classes and the performance drivers of convertible bonds, the performance of -15.8% since the beginning of the year is certainly not pleasing, but it is well within the expected range—in other words, unexpectedly unspectacular.

A closer look at the individual performance drivers of convertible bonds:

• Interest Rates: Convertible bonds, with their bond component, could not escape rising interest rates. The convertible bond market has a relatively short effective duration of about 2 years, making it less affected by interest rate changes compared to the larger bond market, which has a longer duration. Since the U.S. yield curve rose more at the short end than at the long end (non-parallel yield curve shift), the negative effect of higher interest rates was slightly greater than if there had been a constant rate movement across all maturities. The impact of higher interest rates on the convertible bond market is around -4%.

• Credit Spreads: A large part of the convertible bond universe is not officially rated. Of those convertible bonds that do have a credit rating, the majority are sub-investment grade, and only a minority have an official investment-grade rating. For example, the broad Refinitiv Global Vanilla Index includes 565 convertible bonds (most of them non-rated), while the IG equivalent contains just 92 convertible bonds. In volatile times or risk-averse environments, the credit spreads of convertibles tend to widen more than in the rated investment-grade or high-yield bond markets. The impact of higher credit spreads on performance since the beginning of the year is around -2%.
• Stock Markets: Stock markets are and remain the most important performance driver of convertible bonds. The average equity sensitivity is around 45%, with significant regional differences: it is lowest in Asia and Japan at around 35%, in Europe the delta is 43%, and in the U.S. the delta is highest at 50%, making it most exposed to the development of the stock markets. The common stock indices do not really represent the underlying stocks of convertible bonds (different countries, sectors, individual stock weightings). Thus, a direct comparison with stock indices is less informative and can lead to confusion (e.g., in 2020). The performance of the underlying stocks of convertibles is much more meaningful.
• Underlying Convertible Stocks: The stocks underlying the convertibles lost more value in 2022 than various regional or sector indices. This is partly due to the fact that the U.S. accounts for over 50% of the index, and despite this 50% weight, it does not offer much sector diversification, as the IT, communication services, consumer discretionary, and healthcare sectors (especially pharma/biotech) make up around 80% of the market. As a result of the rotation from growth stocks to value stocks and the revaluation of unprofitable tech stocks, the U.S. market was particularly hard hit. Since the beginning of the year, the underlying stocks of the convertibles have declined by -26.9%. Considering the prevailing regional equity sensitivities, weak stock markets had a negative impact of -12% on convertible bonds.

• Volatility: Market volatility has increased by about 50% since the beginning of the year (from just below 20 to around 30, measured by the VIX and Euro Stoxx 50 Volatility Index). The higher volatility had a positive effect on the valuation of the options component of convertible bonds. Based on a Vega exposure of around 0.4% for the convertible bond market, this resulted in a positive impact of +4%.
• Convertible Bond Valuation: Convertible bond valuations have come under pressure since the beginning of the year, particularly in Europe and Asia, and are trading below their theoretical fair value. Japanese convertibles remained mostly stable in terms of valuation, while U.S. convertibles also became cheaper and are now trading more or less at fair value. Convertible bonds with an investment-grade credit rating and a remaining maturity of 1-2 years were particularly pressured in terms of valuation. These bonds were sometimes traded up to 7 points too expensive in the past. The sell-off in the stock markets led to a "reality check" for these convertibles and a re-pricing. Convertibles in the sub-IG sector or without an official credit rating also suffered from the general risk aversion of investors. However, supporting the valuation of the convertible bond market was the fact that primary market activity was extremely subdued this year, so it did not exert additional pressure on valuations. Since the beginning of the year, the convertible bond market has cheapened by around 2% on average and has held up better than in previous "risk-off" periods.

The performance of -15.8% since the beginning of the year for the balanced sector of convertibles (Refinitiv Global Focus Index) is understandable after considering the individual performance drivers and is in line with what could be expected given the credit and equity markets. U.S. convertibles suffered the most from the negative performance of the underlying stocks, while Asian convertibles were more affected by the higher interest rate environment and the widening of credit spreads.

The negative performance of U.S. convertibles this year should be viewed in a longer context. In recent years, U.S. convertibles, thanks to their high weighting in technology and pharma, were the dominant performance drivers of index performance. From this perspective, the 2022 correction in the U.S. convertible bond market could also be seen as a normalization/adjustment to the other regions.

Refinitiv Global Focus Index – Regional Performance (31.12.2018 – 11.05.2022)

The performance of global convertible bond funds for 2022 shows a significant range: more defensive strategies, which focus primarily on investment-grade and lower-equity-sensitivity convertibles, achieved a performance of around -8% since the beginning of the year; strategies with a higher delta or a high U.S. weighting lost around -20%, with some funds even down nearly -30%, which might raise some critical questions.

The performance dispersion of individual convertible bond funds in 2022 clearly demonstrates to investors that simply deciding to invest in convertible bonds is not enough. It remains crucial to align one's own expectations, risk tolerance, and regional/sector allocation with the approach, strategy, and risk profile of the relevant convertible bond funds to avoid unexpected surprises.

Performance H.A.M. GCBF 

As in previous years, the fund was also broadly diversified across regions in 2022 and therefore had greater Asia exposure than typical global convertible bond indices. Many of the Asian convertibles held have low equity sensitivity and exhibit bond-like characteristics with attractive yields to maturity. As a result, the fund was less affected by the weak U.S. convertible bond market but suffered more from rising interest rates, widening credit spreads, and the cheapening of convertibles in the Asian region. Since the beginning of the year, the fund (EUR-A tranche) has recorded a decline of -12.3%, significantly outperforming the global benchmark index (Refinitiv Global Focus Index EUR hedged: -15.8%). This relative outperformance is due in part to the lower U.S. weighting and also to successful individual stock selection, which contributed to better risk diversification within the fund. The underlying stocks of the fund’s positions fell by -19.9% during the same period, while the Refinitiv Global Focus Index declined by -26.9%.

Current Positioning / Opportunities

Global convertible bonds present an attractive alternative in the current environment, as they can participate in a potential positive stock market development thanks to their balanced profile, while also being less exposed to further interest rate fluctuations than the broader bond market due to their relatively short duration of around 2 years. Convertible bonds are also, on average, slightly undervalued to fairly valued, with non-benchmark securities in particular trading below their theoretical fair value, which should normalize over time. The greatest valuation discrepancy remains in Asian convertible bonds.

As a result of the correction in stock markets and the widening of credit spreads, convertible bonds now offer an attractive risk/reward ratio that hasn’t been available in recent years. In the current environment, you can find convertible bonds of very good credit quality with attractive yields to maturity, or convertibles with appealing convexity at conditions that simply haven’t existed in recent years. In 2021, various convertibles were issued in the U.S. with a 0% coupon and a conversion premium of over 50%. Such conditions are definitely a thing of the past. At present, the convertible bond market offers a wide range of opportunities, enabling investment in a broadly diversified, balanced portfolio with multiple sources of return. Our investment objective remains to offer a broadly diversified and balanced global convertible bond portfolio, independent of any index, and always with a focus on managing risks.