Outlook 2023: Clouds to part after ‘perfect storm’ of 2022; modest convertible returns expected

By Abigail W. Adams

Portland, Me., Dec. 30 – The worst-case scenario for the convertibles market played out in 2022 – surging inflation, a hawkish Federal Reserve, geopolitical turmoil, skyrocketing energy costs and recession fears converged to create a “perfect storm” for the market, sources said.

Equities plunged into bear territory, credit spreads blew out and convertibles, a top performer over the past two years, claimed the title of one of the worst-performing asset classes of 2022.

Outright accounts are closing the books with double digit losses, the worst performance since 2008.

While it was also a difficult year for hedge players, there was a wide dispersion of performance with some accounts netting positive returns.

The year ahead will remain a challenging one with monetary conditions tight and equities expected to be choppy.

However, sources are hopeful the majority of damage to the market has already been done.

Returns are projected to be modest yet positive in the year ahead with the new issue market presenting the largest opportunity for gain.

The perfect storm

The events that transpired in 2022 caught global markets by surprise. Historic inflation, historic Central Bank rate increases, Russia’s invasion of the Ukraine, soaring energy costs, supply chain disruptions and recession fears created an unprecedented macro backdrop that simultaneously destroyed credit and equity markets.

Heading into the year, the convertibles market was projected to see single digit returns in 2022.

The Federal Reserve’s historic rate hike campaign changed that.

The Federal Fund target rate was 0% to 0.25% heading into 2022, a level set in March 2020 at the onset of the Covid-19 pandemic.

The Federal Reserve’s lift-off began in March 2022 with a 25 basis point rate increase, which was followed in May by a 50 bps rate increase.

The rate hikes that followed set a new record in the history of financial markets – four consecutive 75 bps rate increases.

The Federal Open Market Committee topped off 2022 with a 50 bps rate increase, which lifted the target rate to 4.25% to 4.5%.

“It was a surprise how quickly rates rose and how quickly it damaged the bond floor,” said Michael Youngworth, BofA analyst and author of the report Year Ahead 2023: Extra Credit. “Bond values and equity values declined at the exact same time. It was a worst-case scenario.”

The abrupt shift from the easy money of the Covid-era to a restrictive monetary policy caused a sharp repricing of credit and equity markets.

The Nasdaq Composite index fell 36.5% from its 52-week high; the S&P 500 fell 27.5%; and the Russell 2000 fell 28.25%.

Indexes are closing 2022 near the lows of the year.

High-yield credit spreads blew out almost 300 bps in the first half of the year from 301 bps in December 2021 to 599 bps in July 2022.

“It really was a perfect storm,” said Manoj Shivdasani, Barclays analyst and co-author of the report U.S. Convertibles Outlook 2023: Bridge Over Troubled Water. “Typically, when stocks are down, rates hold or tighten. This was a completely different environment.”

With bond floors collapsing as equities plunged, convertibles had little to no downside protection. Outright returns sank into the negative double digits.

The return

The past year marked the worst performance for the convertibles secondary space since 2008.

Outright accounts are closing the books with returns of about negative 16% after plunging as low as negative 21.3% in June, according to the Barclays report.

Investment-grade convertibles held up well compared to the non-rated and lower grade portion of the universe with returns of negative 4.5% year to date.

Small cap convertibles outperformed with returns of negative 10.3% compared to large cap returns of negative 18.6% and mid cap convertible returns of negative 11.7%.

By sector, real estate was the laggard with returns of negative 28%; the consumer discretionary, communications services and information technology sectors were next in line with returns of negative 21.7%, negative 20.8% and negative 20.6%, respectively, according to the Barclays report.

There was only one sector to net positive returns in 2022 – energy.

Russia’s invasion of the Ukraine on Feb. 24 sparked an unforeseen geopolitical risk that threw continental Europe into chaos and sparked a massive bull run in energy markets.

WTI crude oil futures surged to a 52-week high of $130.50 in the weeks following the invasion and remained above $100 until July.

While crude oil futures returned to their pre-invasion levels by December, convertibles in the energy sector netted returns of 40.5%, according to the Barclays report.

However, the energy sector comprises only 2% of the market.

The tech companies that were privy to the most aggressive pricing structures in the market once again dragged the market lower with 20 issuers responsible for 40% of the losses in 2022.

Ford Motor Co.’s 0% convertible notes due 2026, DISH Network Corp.’s 0% convertible notes due 2025 and Affirm Holdings Inc.’s 0% convertible notes due 2026 were among them, according to the Barclays report.

The convertibles universe has been fundamentally altered by the preponderance of low to no coupon bonds in the current environment with valuations now skewed toward yield – 80% of the market’s value is now determined by the bond while only 20% is derived from equity, according to the BofA report.

Convertibles now trade with historically low deltas; the U.S. market’s average is 41, which places it in the 14th percentile since 2000.

There are a record number of busted names with 20% of the global market trading with yields above 10%.

The environment will remain challenging in 2022 with deltas low, busted names high, monetary conditions tight and equities choppy.

However, outright returns are expected to turn positive in the year ahead with new issuance providing the best opportunity for alpha.

A better year

The year ahead will remain challenging for the convertibles market with the Federal Reserve signaling its commitment to a restrictive monetary policy until inflation is reduced to 2%.

Equity and credit markets are expected to remain choppy in 2023 with year-end projections for credit spreads that are flat to slightly wide of current levels and the equity outlook low.

However, convertibles market returns are expected to swing to the green although the gains will be modest.

BofA is projecting convertible returns of 4% to 6% in 2023 based on a top-down macro analysis, a bottom-up fundamental analysis and market technicals.

There is cause for optimism in issuer fundamentals with the credit stress among busted names in the universe low, according to the BofA report.

“Some accounts are emboldened by the fact that there’s a lot of yield and credit conditions remain mostly healthy in the space,” Youngworth said.

Equity performance is expected to remain muted in 2023; however, BofA is bullish on small cap stocks, which have historically outperformed during periods of high inflation and slow growth.

The convertibles market is poised to capture some of that upside in the coming year with the Russell 2000 index more closely correlated to the convertibles market than other equity indexes, according to the BofA report.

There are risks to the projection, particularly surrounding the hotly debated recession that many market sources see as the inevitable outcome of the Federal Reserve’s campaign to tame inflation.

“The biggest bear case would be a significant deterioration of credit in a deep recession,” Youngworth said. “In the worst-case scenario, credit spreads blow out.”

Barclays is projecting modest returns of 0.3% in its base case scenario with returns of 6% to the upside and returns of negative 2.4% to the downside.

The base case is assuming negative equity performance of about 6%, investment-grade credit spreads that widen 15 bps, high-yield and non-rated spreads that widen 65 bps, and rates that increase 5 bps.

In the worst-case scenario, equities fall 15%, investment-grade spreads widen 16 bps and high-yield and non-rated spreads widen 75 bps.

In the upside scenario, equities rise 15%, investment-grade spreads widen 10 bps and high-yield and non-rated spreads widen 50 bps.

While returns will be modest, the convertibles market is expected to return to doing what it does best – provide the opportunity for upside participation while limiting the downside risk.

And while the low deltas of outstanding issues will limit the gains made from equity appreciation, the larger coupons and lower premiums of the issuance expected in 2023 offer opportunities.

The hedge

The pain in 2022 was inflicted across asset classes with Treasuries to equities netting negative returns.

Convertible arbitrage players were equally impacted at face value with the HFRX convertible arbitrage index closing 2022 with negative returns of 11.7%.

However, that figure is not an accurate depiction of hedge performance in 2022, sources say.

Returns for hedge players are difficult to project and to track given the diversity and uniqueness of the strategies in play.

However, losses for some accounts were heard to be much narrower than the HFRX index with negative returns in the low single digits.

Some hedge accounts were heard to have outperformed the market and closed 2022 with gains.

Hedge strategies are closely guarded.

However, “anybody who saw a positive return had a lot more than equity on hedge,” a source said.

While their performance has been difficult to track, there has been notable growth of hedge funds in the convertibles market in recent years.

Since the global financial crisis, the composition of the convertibles market has roughly been 2/3 outright accounts and 1/3 hedge accounts.

Hedge accounts are now estimated to comprise about 45% of the market, Youngworth said.

The presence of hedge players in the market is expected to continue to grow with the environment even more accommodating for convertible arbitrage strategies in 2023.

Stock volatility will remain high but rates are expected to be relatively stable, sources said.

And with a projected pick-up in new issuance, there will be greater opportunity for hedge accounts to put their strategies in play.

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