Outlook 2019: Convertibles outperform amid volatility; single digit returns eyed in 2019

By Abigail W. Adams

Portland, Me., Dec. 31 – Returns in the convertibles universe were low in 2018 with the majority of gains made throughout the year wiped out in the fourth quarter.

Despite the losses, convertibles were the outperformer of 2018 with many accounts closing the year in the black while equities and other asset classes end in the red.

The past year has been a wild ride in the secondary market, sources said, with a record amount of supply entering the space and whipsawing credit and equity markets.

After wild swings, accounts on average saw returns of 1% to 5% with outright players again the major benefactors of 2018, sources said. Hedge accounts stood poised to close the year largely flat.

The projections for profits are mixed for 2019 with some placing returns in the 1% to 3% range while others predict returns of 8%.

The macro backdrop is rife with uncertainty and the volatility in the markets is expected to persist into the new year, sources said.

However, demand for convertibles is also expected to persist with the asset class poised to perform well in volatile times.

The returns

“It was the best of times, it was the worst of times,” a market source said – a Dickensian quote to describe conditions in the market heading into the final weeks of 2018.

The year was a tumultuous one and while convertibles outperformed other asset classes, the market was not immune to the hurt felt in the fourth quarter.

Convertibles returns peaked in August, pushing past 9%, according to the Barclays report “In the Wheelhouse.”

However, by mid-December, many of those returns were gone with October marking the third largest monthly loss in the convertibles universe since 2003.

In a single month, convertibles dropped 6.1%, the most since the 13.1% decline in September 2008 and the 17.8% decline in October 2008, according to the Barclays report.

Despite the late-year pain, convertibles stood out as an asset class, closing the year with average returns of 1.4%, according to Barclays.

U.S. convertibles were a driving force of returns for the ICE BofAML G300 Convertibles index with returns at 4.08% through Nov. 30, according to the BofA Merrill Lynch report “Global Convertibles: 2019-the year ahead.”

Tech heavy outright accounts posted the highest returns of the year with some up 5%, a market source said.

However, hedge accounts were underperformers with the HFRX convertible arbitrage index wavering between returns of 0.3% and negative 0.21% into the final weeks of December.

The year was marked by tightening monetary policy, geopolitical uncertainties, escalating trade tensions between the United States and China and wild fluctuations in equity and capital markets.

The volatility is typically a prime environment for hedge accounts to outperform, sources said.

Advanced Micro Devices Inc.’s 2.125% convertible notes moved from outright prices of 150 to 400 in late September only to return to the 248 range in October.

“People make a lot of money with that kind of a move,” a market source said.

While volatility initially helped keep prices up in the market, that changed when credits widened, the source said.

“Broadly speaking a high level of vol. is good for hedge returns, but in order to maximize value you want credit spreads to be stable,” Krishna said. “When credit spreads widen, there's not as much convexity to the downside.”

And credit spreads widened.

The week of Nov. 12 marked a blowout in credit spreads with high-yield credits pushing out to the widest levels in four years – they were trading at the tightest levels since the global financial crisis just weeks before.

While the year was largely a wash for hedge accounts, the collective convertibles universe still beat out other asset classes by a wide margin.

The Bloomberg Barclays high-yield index was posting returns of negative 0.3%, the investment-grade index was posting returns of negative 3.2%, and the equity of convertibles issuers was down 0.9% as of mid-December, according to the Barclays report.

As of Dec. 19, the Dow Jones industrial average was down 5.65%, the Nasdaq composite was down 4.81%, the S&P 500 index was down 6.23% and the Russell 2000 index was down 12.10% year to date.

Returns paled in comparison to 2017 when outright accounts saw gains of 16.5% and hedge accounts 6.5%.

However, the returns were the byproduct of a wild year for financial markets – a year which was, by several accounts, a monumental one for the convertibles market.

The new paper

“Rocking and rolling,” was a phrase used several times by several traders to describe activity in the secondary market after wave after wave of new paper entered the space.

The year was a record setting one for convertibles issuance with the primary market churning out $50.32 billion over 149 deals as of Dec. 18, according to Prospect News data.

The new paper was a boost to trading volume, sources said. Not only were the new deals plentiful but they were substantial in size, adding more liquidity to the market.

The average weekly Trace volume increased to $6.6 billion from $6 billion with turnover increasing to 265% from 232%, according to the Barclay’s report.

However, the rich pricing seen for the majority of the year impacted the profits in the secondary space.

“Typically, you make 2% to 3% on new issues, but things have been on the rich side,” a market source said. “You didn’t really see the pops out of the gate.”

With paper rich, there was also less trading of it, a source said. “You don’t want to buy 3 points rich, so it tends to just sit there,” a source said.

The stock of several issuers also traded off soon after they hit the market with many new deals falling below par a short time after pricing.

While the new paper did not boost liquidity as much as some had thought it would over the past year, the new paper will be a boon in the long run, sources said.

“I’m thrilled,” a market source said. “The convertibles market is growing.”

The players

While the new paper did increase liquidity, some sources were surprised by the lack of selling in the market.

Even as markets swooned and investors fled equities in record numbers, there were few widespread liquidations in the space, a market source said.

Both outright and hedge accounts saw steady fund inflows with arbitrage funds seeing $392 million added to the space versus the $1.08 billion that left in 2017.

Outright funds saw inflows of $1.08 billion.

There was an increased presence from outright accounts, which drove the rich pricing and demand for paper from the tech sector, sources said.

However, hedge accounts were more active in the secondary space with a buy-sell ratio of 1.12x versus outrights 0.93x, according to the Barclays report.

There was also an increased presence from cross-over equity investors interested in increased positions in certain names, sources said.

Convertible ETFs also continued to increase their presence in the market with ETFs now consisting of 9% of tracked assets, according to the BofA Merrill Lynch report.

The year of Tesla

The year was a roller-coaster ride for financial markets that was marked by tightening monetary policy, trade tensions with China, plummeting oil prices, political instability and Tesla Inc. CEO Elon Musk.

While the year was filled with surprises and drama, nothing captivated or kept the markets on edge quite like Tesla.

“That was a wild toad ride,” a market source said.

From the blowout with analysts on the second-quarter earnings conference call to Musk’s infamous take private tweet to the SEC lawsuit and settlement, Musk was never far from the headlines. And the headlines never failed to move Tesla’s stock and convertible bonds.

There was speculation for much of the year about Tesla’s ability to cover its maturing convertible bonds with several analysts pointing to the maturing debt as the straw that might break the camel’s back.

However, the biggest surprise from Tesla came in the fourth quarter with its stock and convertible notes outperformers as the rest of the market swooned.

Posting its largest profit since its inception in the third quarter, Tesla stock surged and the upward momentum continued through mid-December.

SolarCity Corp.’s 2.75% convertible notes due Nov. 1, 2018 were paid off with little fanfare and investors’ jitters about the company seemed to settle.

“That put a little rest to the market,” a source said. “All of the Muskiness got pushed aside.”

Then stock surpassed the $359 conversion price on Tesla’s 0.25% convertible notes due March 1, 2019.

While flirting with the number in early December, Tesla stock traded above the conversion price for the full Dec. 10 week.

Stock has come in since, closing Dec. 18 at $337.00.

However, Tesla announced if the notes are convertible at the time of their maturity, they will be settled half in shares and half in cash.

The announcement that Tesla would cover half of the $920 million amount outstanding of the 0.25% convertible notes in cash was an expression of confidence in itself, sources said.

If the notes can be converted out at their maturity, it will be a coup for Tesla and a huge boon to its entire capital structure, another source said.

The crystal ball

The forecasts for returns in 2019 were mixed, but there was agreement that the volatility and uncertainty in the markets will persist amid the continued backdrop of geopolitical uncertainty, trade tensions and monetary tightening.

Barclays expressed optimism that returns would improve in 2019 projecting returns of 8.4% with returns of 3.5% in the downside scenario and 10.4% in the upside.

BofA Merrill Lynch took a more bearish approach with returns projected to be in the 1% to 3% range.

In Barclays’ scenario, convertible holders will benefit from increased interest rates, capturing returns in the form of higher coupons, provided the primary market continues at a steady pace.

Equity appreciation is also expected to continue to be a driving force of returns, according to the Barclays report.

High sector concentration and a pullback in equities are potential risks to the forecast.

And the convertibles universe is increasingly becoming concentrated with the tech sector accounting for about 50% of the total market.

However, within the tech sector there is a dispersion of industries, including semiconductors, software, the internet of things, and IT services, according to the Barclays report.

While some pointed to a pullback in tech as a risk in 2019, others see the sector as a continued driving force of returns in the year to come.

The valuations of the tech companies in the convertible universe look reasonable relative to sales growth and EBITDA margins that are better than the broader tech universe along with more growth capital being deployed, Krishna said.

BofA Merrill Lynch is expecting a slowdown in the tech sector – a contributing factor to the 1% to 3% returns forecast for the coming year.

While BofA Merrill Lynch expects returns to be low in 2019, convertibles are still positioned to outperform equities, which are forecast to be flat.

Resolution to the trade war would change the scenario to the upside with convertibles capturing returns from a pop in tech stocks.

However, in BofA Merrill Lynch’s scenario, resolution is not expected to come in 2019.

While the scenarios for the year ahead diverged, analysts, traders, syndicate sources and investors were in agreement – 2019 will be a volatile year, rife with uncertainty and unpredictability.

Sources also agreed – convertibles as an asset class are well positioned to weather the storm and outperform in volatile times.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.