Convertible Bonds im Fokus

Despite a clearly bullish consensus view at the start of 2014, geopolitical tensions and emerging market volatility garnered much attention and led to unexpected performance trends in the first quarter as interest rates trended lower and credit outperformed  equities. Once again, we were reminded that “the only function of economic forecasting is to make astrology look respectable” (JK Galbraith). Despite the unexpected turn of events in the first few months of the year, convertible bonds performed very well compared to other asset classes. Indeed, global equities (MSCI World €-hedged Index) returned +0.4% and global credit (Barclays Global Credit Index) posted returns of +2.6%, while our benchmark (UBS Global Focus composite) returned +3.2% during the period. 

As we enter the second quarter of 2014, investors and analysts alike have returned to monitoring the actions of the global central banks. Indeed, the markets’ reaction to the Federal Reserve’s March Federal Open Market Committee meeting and press conference reminded everyone that US monetary policy remains the focal point for global investors. Given the low levels of inflation generated by the US economy and the mixed messages sent by leading economic indicators, we do not expect the accommodating monetary stance to change in the near future. Meanwhile, it seems inevitable that the European Central Bank will be forced into some form of Quantitative Easing over the coming weeks or months, in order to avoid a deflationary spiral in the euro zone (inflation for the region is now as low as 0.7%, with some areas such as Spain already experiencing deflation). 

It is clear that markets were underwhelmed by US economic indicators in the first quarter. Indeed, the much-discussed sector rotation, away from bio-tech, software and other high-growth sectors in favor of more defensive names with visible cash-flow streams, can largely be attributed to a risk-off bet triggered by macroeconomic concerns. Over the coming weeks, some much-awaited economic indicators should clarify the dynamism or lack of dynamism of the US economy. This in turn will set the tone of global markets in general and emerging Asia in particular. It was noteworthy in March that China experienced its first ever default in its on-shore bond market, ending an era of minimal default risk. While disappointing growth in the region has had an impact on performance, the Asian instruments in our portfolio resisted well and are well positioned to benefit from an inevitable rebound (once the market risk is re-priced). 

During March, global convertible issuance totaled USD 7.6 billion (source: UBS), better than last year (USD 6.5 billion in March 2013), raising the Q1 2014 total to USD 21 billion. Once again, more than half (USD 4.2 billion) of this month’s issuance can be attributed to the US, with European issuance totaling USD 2.2 billion (USD 5.6 billion for the quarter). New European issues such as the large ones from Fresenius and Iberdrola (both over USD 500 million in size, and now included in the LOF Convertible Bond portfolio) were particularly welcome, since we are now seeing pockets of expensiveness within the European convertible bond universe (see valuation chart in this report). More specifically, the high level of demand for investment-grade European convertible bonds has pushed up valuations to a point where synthetics become a clear alternative. 

Convertible bonds appeared to take a breather in March with near-flat global performance, reflecting uncertain equity markets (the MSCI World Index fell 0.5% over the month) and globally stable credit and rates. The LOF Convertible Bond Fund returned -0.17% in March, compared to +0.25% for its benchmark. In the first quarter, the LOF Convertible Bond Fund has fared much better than equities (+2.2% versus +0.40%) with much lower volatility (4.5% annualized versus 10.0%). We are, however, slightly behind our benchmark (+3.1% in Q1 2014, with volatility of 5.1%).  

Our relative performance suffered in March from the sell-off in the biopharma sector (Gilead and Shire). In absolute terms, exposure to US consumer cyclicals was punished, with Tesla and Priceline particularly hard hit by the sector rotation within equities. European sectors were the best contributors to performance last month, with utilities (GDF) and industrials (Siemens, Air France, Deutsche Post) adding the most value. In the first three months of 2014, our European exposure contributed 90bps of absolute performance. However, our higher sensitivity to US underlying shares (58% vs 48% for the benchmark) cost the portfolio approximately 40bps in relative performance over the period.