Markets are transitioning to a new investment landscape where diversification will be a key focus. Convertible bonds are one of the asset classes that should benefit from asset allocation flows looking for diversification.
We expect a rise in equity volatility in 2024 and believe this will be a key theme for financial markets. When volatility rises, convertible bonds tend to outperform equity markets. Another powerful argument for equity investors to allocate to convertible bonds is the income component, which has recently switched back in favour of convertibles, offering better coupons than dividends.
The fixed income features of the convertible bond universe continue to offer an attractive profile with a low sensitivity to interest rates and a strong credit quality (more than 40% investment grade). The diversification benefits of convertible bonds for traditional fixed income investors remain in place. We expect the primary market to continue to expand in 2024. Historically, a pickup in new issuance has been a positive catalyst for the convertible bond asset class. We expect the coming period to be no exception.
Why buy convertibles now: the (ultra) short version?
Have market participants adapted to the post-Covid world? We do not think so. Inflation is likely to stay elevated for the next few years, bringing monetary policy into a new regime. Long-term interest rates will remain volatile as many countries have adopted a more accommodative fiscal policy approach. The range of potential outcomes for economic growth has never been so wide - from recession to re-acceleration! In the face of this new, highly uncertain investment landscape, the keyword for asset allocation in the coming years will be ‘diversification’.
To put things bluntly, in the days of quantitative easing (QE), ‘everything was going up’, and volatility was always low. In that environment, the benefits of diversification were hard to defend; large-cap ETFs and high-carry strategies were all the rage. However, things have changed, and in the future, investors will have to think a lot more about the risk profile of their portfolios. Outperformance is likely to come from unexpected, overlooked segments of the market. We believe this shift towards a higher degree of diversification has only started. Convertible bonds, from their hybrid nature, are a natural candidate to contribute to portfolio diversification. We expect this theme to drive renewed interest in the asset class and a re-rating.
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