Recovery Convertibles: Searching for a “Sweet Spot” Investment
1 RECOVERY CONVERTIBLES Searching for a “Sweet Spot” Investment
Unusual for an investment, convertible bonds can optimize Funding the Reopening both sides of a transaction. The bonds’ embedded call option offers buyers the potential for profit no matter Mid cap and growth companies, quite often in the tech which way the market turns. If the underlying equity rallies, sector, routinely issue convertible debt as a means of they can exercise the option and end up with a gain. If it conserving cash in a phase of rapid expansion. In adverse falters, the bond feature reduces the likelihood of principal phases of the economic cycle, sound, well-established loss and can secure a periodic coupon payment. And if the companies in hard-hit sectors may also tap the convertibles value jumps around erratically, convertibles’ dual nature market for the funds to see them through the rough patch. gives them a ready market, enabling them to profit from Last year’s travails produced a bumper crop of such the volatility itself. convertible issuance (Exhibit 1). For the sellers—the issuers—convertibles can offer an The bumper crop has in turn magnified the sweet spot inexpensive source of funding. Convertibles typically where prudent convertible investors may stand to profit carry lower coupons than conventional bonds without from a range of potential return streams (Exhibit 2): the equity option, which translates, of course, to lower • Transient pressures may well have pushed a stock’s interest costs for companies focused on conserving cash. price below what long-term fundamentals would They diversify an issuer’s obligations, and if and when warrant. bondholders exercise their call options, they diversify the • Bond prices and coupons may be discounting the issuer’s shareholder base. In addition, upon the exercise of issuer’s true value. the embedded options, they automatically deleverage the issuer’s balance sheet. • The undervaluation of the option embedded in the convertible bond reflects an implied volatility much lower than the equity price. Exhibit 1 COVID-19 Issuance Soars in the Most Susceptible Sectors otels, Restaurants Darwinian Investing Leisure Airlines The challenge of investing in “recovery convertibles” mirrors but in our view does not precisely resemble the Real Estate 2019 challenge convertible investors face when they evaluate Specialty Retail 2020 growth companies. Both types of endeavors involve a sort Entertainment of “survival of the fittest” investment research. But where Oil, as growth investing seeks to identify issuers with capital Consumable Fuels structures ample and fit enough to capture emerging Road Rail opportunities, recovery investing seeks to identify issuers Auto Components with capital structures resilient enough to survive a 0 2,000 ,000 ,000 ,000 10,000 downturn and take part in a future recovery. (USD Millions)
As of 31 December 2020 Picking out convertibles positioned for recovery may have Source: BAML, Bloomberg one advantage over the conventional hunt for growth.
2 The success of a growth convertible depends on a future Exhibit 2 that is still uncertain. Recovery convertibles have a proven The Recovery Convertible Sweet Spot track record and we believe merely await a turn in the cycle to rebound—although coming out of an unprecedented pandemic, the cycle may take unforeseen twists. d Implied alue Vo rv lat That “unknown unknown” places even more emphasis e ili nd ty U on fundamental analysis in an asset class that calls for n erv l e as much intensive research as any other. Indeed, the Cre it Co onent convertibles market does not so much resemble a broad asset class but rather a mosaic of component parts. In addition to analyzing the balance sheets and management capabilities of each issuer, convertible investors have to analyze the terms of each issue to determine whether the n erv l e I cte E ity interests of the seller fully align with theirs. Sector Co onent Navigating Uncharted Tides in a Sea
of Liquidity lo et ba ark l Convertible M Despite, or maybe because of the extreme uncertainties regarding the future course of the economy, the recovery As of 31 December 2020 convertibles market offers distinct advantages. Because of This information is for illustrative purposes only Source: Bloomberg, Jefferies record issuance last year and expectations of more to come in 2021, it enjoys a high degree of liquidity both in the primary and secondary markets. Bid-ask spreads are tight—much tighter, in fact, than those in high yield bonds (Exhibit 3).
Exhibit 3 Convertible Recovery—Market Has Regained Its Footing after Last Spring’s Disruption ( ) 2.0
1.
1.0
Nor l R n e or Bi s S re s 0.
0.0 Dec ’19 Jan ’20 Feb ’20 Mar ’20 Apr ’20 May ’20 Jun ’20 Jul ’20 Aug ’20 Sep ’20 Oct ’20 ov ’20
As of 31 December 2020 Source: BAML, Bloomberg, Refinitiv/Thomson Reuters, Trace
3 Recovery Convertibles: Searching for a “Sweet Spot” Investment
And because prospects for reopening are brightening even The Worst-Kept Secret in Convertible while the realities of the shutdown remain, we think the convexity of recovery convertibles has become compelling. Investing Convertibles’ fixed income defensiveness against the Convertibles don’t lend themselves to passive “index persistence of current conditions and their implied equity investing.” In our view, results for the convertible investor participation in an eventual recovery are enriching their depend on a manager’s process in analyzing not just a value as securities capable of gaining advantage from company’s operating and financial fundamentals but either eventuality. also the structure of each particular issue. The record of In broad outline, then, the near-term future for convertibles Lazard’s global convertibles team testifies to the rigor and looks to us a lot like its past: potentially greater returns consistency of a process backed by world-class global than fixed income with less volatility than stocks. The research. Its five- and 10-year records place it among the prospect of a robust economic recovery coming out top decile of its peers, as do its returns in both 2019 and of a long and stubborn slump, with all the early-stage 2020. Since inception, the team has compiled such gains market volatility that entails, seems in our view to favor without a single default in its portfolios. We believe this convertibles now even more than in the past. Again, process, steadily refined to identify value and screen out however, we must emphasize the wide range of outcomes default candidates, gives our strategies an edge in the that make up the asset class returns. recovery environment we anticipate.
This content represents the views of the author(s), and its conclusions may vary from those held elsewhere within Lazard Asset Management. Lazard is committed to giving our investment professionals the autonomy to develop their own investment views, which are informed by a robust exchange of ideas throughout the firm.
Important Information Published on 23 March 2021. Any projections, market outlooks, or estimates in this document are forward-looking statements and are based upon certain assumptions and should not be construed to be indicative of actual events which will occur. An investment in bonds carries risk. If interest rates rise, bond prices usually decline. The longer a bond’s maturity, the greater the impact a change in interest rates can have on its price. If you do not hold a bond until maturity, you may experience a gain or loss when you sell. Bonds also carry the risk of default, which is the risk that the issuer is unable to make further income and principal payments. Other risks, including inflation risk, call risk, and pre-payment risk, also apply. Securities in certain non-domestic countries may be less liquid, more volatile, and less subject to governmental supervision than in one’s home market. The values of these securities may be affected by changes in currency rates, application of a country’s specific tax laws, changes in government administration, and economic and monetary policy. Derivatives transactions, including those entered into for hedging purposes, may reduce returns or increase volatility, perhaps substantially. Forward currency contracts, and other derivatives investments are subject to the risk of default by the counterparty, can be illiquid and are subject to many of the risks of, and can be highly sensitive to changes in the value of, the related currency or other reference asset. As such, a small investment could have a potentially large impact on performance. Use of derivatives transactions, even if entered into for hedging purposes, may cause losses greater than if an account had not engaged in such transactions. This document reflects the views of Lazard Asset Management LLC or its affiliates (“Lazard”) based upon information believed to be reliable as of the publication date. There is no guarantee that any forecast or opinion will be realized. This document is provided by Lazard Asset Management LLC or its affiliates (“Lazard”) for informational purposes only. Nothing herein constitutes investment advice or a recommendation relating to any security, commodity, derivative, investment management service, or investment product. Investments in securities, derivatives, and commodities involve risk, will fluctuate in price, and may result in losses. Certain assets held in Lazard’s investment portfolios, in particular alternative investment portfolios, can involve high degrees of risk and volatility when compared to other assets. Similarly, certain assets held in Lazard’s investment portfolios may trade in less liquid or efficient markets, which can affect investment performance. Past performance does not guarantee future results. The views expressed herein are subject to change, and may differ from the views of other Lazard investment professionals. This document is intended only for persons residing in jurisdictions where its distribution or availability is consistent with local laws and Lazard’s local regulatory authorizations. Please visit www.lazardassetmanagement.com/globaldisclosure for the specific Lazard entities that have issued this document and the scope of their authorized activities. HBX128072