Outlook 2024: Convertibles to net modest positive returns; crossovers to bring arb opportunities

By Abigail W. Adams

Portland, Me., Dec. 29 – The convertibles secondary market saw a solid performance in 2023 with outright and hedge accounts netting positive returns after the double-digit destruction of the previous year.

While in positive territory throughout the year, market returns lagged the explosive growth in equities with the small cap index, which the market most closely correlates with, underperformers for much of the year.

However, the rates, recession and refinancing debates that weighed on the market for much of the year were resolved in the final weeks of 2023 with the market and the Federal Reserve reaching consensus that an economic soft-landing with rate cuts were in store for 2024.

Accounts are now closing the books with the market at the height of the year and with convertibles outshining most fixed income asset classes.

Market returns are expected to moderate in the coming year although they will remain positive and competitive.

There will remain pockets of opportunity in the outstanding universe.

Price appreciation from busted convertible notes and buybacks and exchanges of maturing convertible notes are expected to continue to net rewards.

However, the biggest driver of returns will remain new issues with a continued uptick in new deal volume expected, particularly from crossover issuers.

There will be increased opportunity for equity arb plays with the influx of new issuance expected.

Crossover issuance from the high-yield and investment-grade markets are also expected to give rise to more complex hedge strategies, increasing the dynamics of an already dynamic market.

A solid year

The convertibles secondary space is closing 2023 on a high note with the solid performance seen throughout the year boosted by the spectacular market rally in mid-November that carried over into the final weeks of the year.

While equities took the prize as the largest gainers of 2023, the performance of equity indexes were mixed with the small cap index, which most closely tracks the convertibles universe, the laggard.

However, the Russell 2000 index was the outperformer into the final weeks of the year as the market priced in rate cuts. The convertibles market was lifted along with it.

Global outright convertible returns were marked at 5.9% with the domestic market up 4.4% in mid-November, according to the BofA report “Global Convertibles Year Ahead 2024: Rates are a double-edged sword.”

Outright returns were pegged at 8.1% as of Dec. 5, according to the Barclays report “U.S. Convertibles Outlook 2024: Steady sailing amidst macro tides.” They shot up to 12% as of Dec. 14.

Hedge accounts also logged a strong performance in 2023 with the HFRX index up 5% as of Dec. 5.

Equity-sensitive convertible notes were the best performer in the market with that portion of the universe the best suited to capture the gains in equities.

However, the busted convertibles universe also netted solid rewards as the recession that was widely expected to hit in 2023 failed to materialize.

In mid-November, prior to the late-year rally, the busted portion of the convertibles universe was hailed as the best performer with global busted convertible notes up 9.6% versus the 3.8% gain in the broader market, according to the BofA report.

The market entered 2023 in a defensive position with the preponderance of issuance in 2020 and 2021 in busted and distressed territory.

However, the resilience of the economy took the market by surprise and busted names with relatively strong credit profiles saw an influx of buyers.

MicroStrategy Inc.’s convertible notes were a notable example.

MicroStrategy’s 0.75% convertible notes due 2025 traded as low as 47 in early January 2023.

The resurgence of the Bitcoin bulls sparked a phenomenal rally in the company’s stock, which was up 295% as of Dec. 14.

MicroStrategy’s 0.75% convertible notes surged from distressed to equity-sensitive territory with the notes on a 152 handle as of Dec. 14.

MicroStrategy’s 0% convertible notes due 2027 opened 2023 on a 37 handle. They were trading at 83 as of Dec. 14.

MicroStrategy’s 0% convertible notes due 2027 and 0.75% convertible notes due 2025 netted total absolute returns of 125% and 232%, respectively, according to the Barclays report.

Buybacks and exchanges were also a strong source of returns as convertible issuers addressed their looming maturities.

Approximately 20% of the deals to price in 2023 involved the buyback of outstanding convertible notes, according to the Prospect News database.

While the new issuance provided opportunities, the “real kiss” is always in the buyback, sources say.

Convertible returns are expected to moderate in the coming year with new issuance to remain the major driver of alpha.

And with an influx of issuance from high-yield and investment-grade credits expected, sources expect to see an uptick in different arb strategies.

Return expectations

Outright convertible returns blew into the double digits in the final weeks of 2023 as markets cheered on the end of the Fed’s rate hike campaign and priced in rate cuts.

And while convertible returns will remain positive and competitive with other asset classes, returns are expected to moderate in the coming year.

The relatively low delta of the convertibles universe, outflows from the asset class and muted expectations for equities amid still high rates and the anticipated economic slowdown are expected to weigh on the market.

BofA is expecting the U.S. convertibles market to produce outright returns of 7% to 9%.

Barclays pegs returns at 4% in their base-case with upside potential for 10% if equity markets perform better than anticipated.

The strong yield now available in the convertibles market and equity appreciation were pointed to as drivers of returns in the coming year.

However, the delta of the market is still low due to the preponderance of busted convertible notes with the index delta pegged between 35% and 45%.

Buybacks and price appreciation of busted convertible notes are expected to provide continued opportunity in the coming year.

However, new issuance is once again expected to be the greatest driver of convertible performance.

The cheapness baked into new deals and the balanced profile they provide will give greater opportunity to capture the underlying equity’s upside potential.

Return projections are limited to the long only portion of the market with hedge returns difficult to estimate.

“Arbitrage returns are tough to project because it involves so many different things,” said Venu Krishna, Barclays head of U.S. equity strategy and equity linked strategies. “There are special events, flush outs, buyback plays, volatility arbitrage, credit, cap structure relative value, etc. It’s not narrow or easy to track.”

The short stock, long bond play will still be the “bread and butter” of convertible arbitrage, Krishna said. “But around that there are a lot of nuances.”

The influx of investment-grade issuance in 2023 resulted in a notable uptick in rate hedge strategies in the market, sources said.

The high-yield and investment-grade crossover issuers expected to tap the convertibles market in 2024 will bring with them increased opportunity to employ more complex hedge strategies.

And with the market still a healthy mix of 55% outright accounts and 45% hedge accounts, there will be plenty of market players to put those strategies into use.

Current projections for market returns are based on a soft-landing scenario with recession the most prominent risk to what is expected to be a relatively healthy and stable year.

While the recession debate is still alive and well, the scenario has largely been pushed to the back burner.

However, sources do expect a pullback in credit and equity markets after the explosive rally in the final weeks of 2023.

And in such a pull-back, the convertibles market is well positioned to do what it does best – provide risk-controlled returns.

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