Pension funds and other institutional investors have reversed outflows that plagued convertible bonds after the credit crunch, forcing managers to bump up against capacity, as David Walker reports
Convertible bond managers, a group that faced heavy redemptions and a 27% fall in their asset class in 2008, are now capping funds after strong inflows and market recovery left some hitting capacity.
Many not curbing inflows yet are considering it –citing maintaining returns and investment freedom – and all say ‘soft closing’ portfolios is specific to funds.
The managers add the return of institutional capital, including by pension funds, since the crunch is welcome in bringing more trading styles and mind-sets to the market.
F&C has capped its long-only Global Convertible Bond fund as its program exceeded €2bn ($2.8bn), RWC Partners is nearing capacity on its Global Convertibles fund, and Schroders has set limits – not yet reached – for its products.
Not all managers have capped. CQS, with about $1.2bn in convertibles via co-mingled and bespoke, long-only and long/short products, remains open, as do funds at DWS Investments.
Christian Hille, the DWS Invest Convertibles fund’s lead manager, cites liquidity in the $500bn market, average tradable sizes, new issuance activity and market coverage as key reasons to cap. DWS has €3.5bn in convertibles but said a broadening universe especially in Asia Pacific means it “does not see an issue with respect to capacity” under current conditions.
Capacity changes with market and liquidity environments, noted Dan Mannix, RWC Partners’ head of business development.
“It is not simply the size of the fund you look at –one must consider as a fiduciary, in extremis can you still meet redemptions? It is also about knowing your investor base. If you have, for example, lots of tactical asset allocators, it is prudent to assume in extremis they may be quicker to exit.” RWC will close its $1.25bn Global Convertibles fund at around $2bn.
“Capacity within convertible bond funds has to be very carefully managed [and] the liquidity of the asset class and size of the market are key considerations. In this asset class there are a lot of smaller issues where you have to be a sensible size to take advantage of them, and for them to have a meaningful impact on your performance,” Mannix said.
“The opportunity set a convertible manager has got is capacity-constrained, and managers cannot perform well if they cannot access the best issues. If we managed $2.5bn or $3bn, we would not necessarily be able to access those effectively.”
Manager resources and narrow mandates – around emerging markets or ratings criteria, for example – also play a part in decisions, said Oliver Dobbs, CQS’s chief investment officer for portfolio management.
For F&C, it was inflows, and new issuance increasingly moving to sub-investment grade and unrated companies, said Anja Eijking, F&C head of convertibles. “Within our investment style on focusing on quality issuers and some 65% invested in implied investment grade convertibles, this meant the investable universe is shrinking”.
Taking excess inflows can force managers to hold near benchmark weights and only liquid securities, which is “not always the best in terms of downside risk control“, said Dorian Carrell, Schroders’ global convertibles analyst. Schroders will close its $600m Global fund at around $2.5bn, and conduct detailed capacity analysis when its $180m Asian fund hits $1bn.
“You have to look at the amount of outstanding (issues) and what percentage is tradeable. You also must have regard to who holds the issues, because you can have a large issue, but held only by one or two players so in effect it is not liquid,” Carrell said.
Whether or not their funds are capped, managers concur the broad post-crisis recovery rally in their $500bn market is over. Convertibles jumped 24% in 2009, over 9% last year to trade around fair value now, they say.
Dobbs said: “There is big dispersion [in valuations], and therefore a lot of opportunities. You can find cheap issues to buy, or avoid expensive ones if you are a long-only fund manager. You need to look at as many different types of convertible issues as possible. If you have fairly limited goals, it could limit the size you can be in that space.”
Finding ratchet clauses in bond documents has been a boon for CQS, in cases such as Louis Vuitton’s planned €3.7bn takeover of Bulgari where Louis Vuitton must pay holders of Bulgari convertibles “significantly” as part of its deal.
Research is also needed, for example, to identify where European government entities may support issuers, “or where an issuer is just a standalone entity, which under different circumstances could be let adrift”.
Many managers are also researching new geographies.
Schroders is examining South America, and already invests in Asia, the fastest growing market for convertibles last year. “From a long-term perspective we think Asia represents a fantastic opportunity and the convertible market there is underdeveloped.
“Companies that issue them are typically small- and mid-sized and trying to finance their growth, which typifies companies in the fast-growing economies, and we expect that will continue because of rising rates and rising equity markets, which are ideal conditions for issuing convertibles.”
After the crisis
Managers note the composition of investors in the market changed dramatically post-crisis, reverting to its pre-crunch status quo when various institutional investors held about 70%. It is healthier than in the mid-2000s, when a similar dominance was enjoyed by leveraged players, chiefly hedge funds and bank trading desks.
Carrell said one problem of having so many hedge funds before their leverage – some estimates suggest 3.5 to four times assets – heightened market volatility. Those remaining are about 2.5 times leveraged, he said.
“We also have credit buyers, long-only convertible funds, credit arbitrageurs and some equity income players in the market, too. The inevitable next step is more defensive equity income managers looking for a coupon clip, and we think the coupon clip [from convertible bonds] gives equity players the equivalent of a dividend yield, but not a dividend that can be cancelled.”
According to brokers, issues have over 200 takers, compared to about 50 historically. “In the market, you want investors who will not immediately short the equity, and who are in [the market] for the long term,” Carrell said.
The contraction of speculators might have increased capacity for products now, while decreasing crowding in trades.
“You could see by the new issue calendar the crowding out in the mid- to late-2000s. The calendar became increasingly exotic, suggesting people were pushing the frontiers a little,” Dobbs said.
Before the crunch, said RWC’s Mannix, many investors did not consider convertibles a separate asset class, “but the stress of 2008 and 2009 has highlighted how long-only convertibles could be used”.
Adding them to a diversified portfolio can improve the efficient frontier – that is, higher returns for less risk, said CQS’s Dobbs. “In an increasingly bimodal trading environment – where you are likely to get volatility on the upside and downside – convertibles as a long-only product operate very well.
According to F&C’s Eijking, holding them allows “the gradual and smooth locking-in of profit on convertibles that benefited from strong equity returns, and reinvesting back in convertibles that once again offer opportunity to participate in rising share prices with reduced risk profile.
“In the long run, convertibles outperform equities while standard deviations are only half [that of equities]. Compared to credits, one generally receives half the coupon on convertibles. If convertibles mature out of the money, you have an opportunity loss of half the coupon, however unlimited upside potential with the underlying share price.”
Schroders’ Carrell points to convertibles’ usefulness to fixed income investors, due to a correlation of under 50% to bonds.
Phil Irvine, co-founder of London’s PiRho Investment Consulting, said pensions should consider convertibles, as “a legitimate asset class dipping into equity beta, but with the promise of a bond floor. Allocating forms part of a broader trend of investors saying they want participation in the equity market, but in a more risk-controlled way.”
He cautioned, however, because market liquidity can fall sharply, investors should bear in mind their own liquidity needs, and co-investors’, too.
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