The ongoing trade war and geopolitical uncertainty has made the Asian convertible bonds market a very interesting opportunity for investors as we enter the fourth quarter.
If you look across the convertibles universe, and the wider fixed income market, we are at a very interesting juncture, with negative yielding debt and historically tight credit spreads in many regions. However, this is creating opportunities in certain areas, and in particular the Asian convertibles market.
We have seen that Asian convertibles can demonstrate effective capital preservation, as they did in 2018, and during 2019 to date, returns have also been solid on the upside.
If you look at the longer-term track record of Asian convertibles in USD and compare those against equities in the region (as measured by the MSCI Asia-Ex Japan Index hedged into USD), the gains for convertibles have been about 2/3 of Asian equities, but with 1/3 the volatility on a 1-year trailing view.
This performance is in line with longer-term history.
The US / China trade war has been a clear headwind recently for the region, with president Trump's tweets moving some underlying stocks by up to 5% or more in a day. In addition, the ongoing protests in Hong Kong have added more headline risk and market volatility. This is particularly clear in some sectors, such as technology, but if you dig a little deeper into the sell-off, you see a dislocation between expectations and share prices that can create opportunities to buy companies with good fundamental characteristics.
For example, while the trade war might legitimately impact areas such as component manufacturers (like semiconductors) there has been a real change in Asia into the software as a service market, particularly for domestically-focused firms. The trade war has had far less of a real-world impact on social media platforms in China, for example, so we would expect valuations to normalise.
Ctrip,com is one issuer of convertible bonds where we believe that recent market moves are not reflective of the longer-term fundamentals. Ctrip is China's largest online travel agent, with growth potential based on domestic - Chinese consumers spending more on travel as their incomes rise - rather than external factors. This means that the company's future earnings should be affected to a lesser degree than a Chinese exporter by any trade war.
Investor protection and credit quality
At the same time, Asian convertibles can earn returns from upside participation from stock moves, without having to accept more credit or duration risk just in order to earn income.
Many Asian convertible bonds have credit enhancing features such as investor put options, which leads to higher bond floors. We can also create a portfolio from existing Asian convertible bonds where the average credit profile is investment grade or equivalent.
Many balance sheets from Asian convertible issuers are in good health, so that the inherent financial strength of the companies is attractive
Further advantages from convertible structures
Many Asian convertible bonds - by our estimate, nearly 45% of the market - trades less than 5% from their bond floors, but still offer reasonable equity sensitivity with some yield.
This gives a positive benefit from rising share prices, but with less downside, should underlying stocks fall. What this means is the convertibles market in Asia has now become a much more credible yield story, with average yields at around 3%, so investors are being paid to wait for share prices to recover, even if hedging currency exposure back to euro or another lower-yielding currency. Also, volatility can be a positive for convertible bonds, given that rising volatility increases the value of embedded optionality, and Asia has historically modelled as the cheapest region within the convertible universe.
If you then factor in the global bond market where we now have more than $15tn in government bonds trading with negative yields globally and credit spreads at historically tight levels, Asian convertibles look especially cheap.
Uday Sikand is a convertibles fund manager at RWC Partners