Outlook 2020: Convertible returns hit 20%; outperformance expected to continue in 2020

By Abigail W. Adams

Portland, Me., Dec. 31 – The stars aligned for the convertible secondary market in 2019 with returns outperforming all other fixed income asset classes.

Convertibles were able to capture the upside of skyrocketing equities and tightening credit spreads and logged one of their best years since the financial crisis.

The Bloomberg Barclays US Convertible index saw returns of 20% as of Dec. 6, according the Barclays report, “U.S. Convertibles Outlook 2020: Room to Run.”

Outright players were the major benefactors with hedge players also breaking into positive territory after closing 2018 in the red.

Mandatory convertibles were the clear outperformers in the secondary space.

While a pull-back is anticipated in 2020, the forecast remains positive with convertible returns expected to continue to outperform other asset classes.

However, despite the stellar year and positive trajectory, risks remain.

There are several wildcards that could easily push convertible returns into negative territory in 2020, sources said.

Convertible returns

The stars aligned for the convertible market in 2019 with skyrocketing equities, tightening credit spreads and declining rates converging to create blockbuster returns.

The Bloomberg Barclays US Convertible index logged returns of 20% as of early December.

It was the second-best year for convertibles since the financial crisis and the best year since 2013 when returns were 24.4%, according to the Barclays report.

The majority of gains were realized in the first quarter with returns dropping to the single digits in the second and fourth quarters and turning negative in the third.

Despite the choppiness, convertibles outshined all other fixed income asset classes with high-yield returns of 12.5% and investment-grade returns of 14% as of early December, according to the Barclays report.

“This was sort of an inflection year for converts,” said Venu Krishna, Barclays analyst and co-author of the report “Room to Run.”

“There was healthy organic growth, a significant pickup in issuance, liquidity improved, and valuations remained reasonable even as spreads and rates rallied and convert underlying equities outperformed. Everything seemed to go right,” Krishna said.

Outright players were again the major benefactors of the blockbuster year. However, hedge players also reaped the rewards with the HFRX index posting returns of 5.5%.

While the convertibles market saw a record year for issuance, “not a ton was made off of the new deals,” a market source said.

However, the influx of new paper helped drive liquidity in the secondary space, which continued to improve year over year.

The average weekly Trace volume was $7 billion with turnover increasing to 240%, according to the Barclays report.

Volume was $6.4 billion and turnover 228% in 2018.

While it was by all accounts a phenomenal year for convertibles, returns were not evenly distributed throughout the market.

The winners

Despite an overall stellar year for the market, convertible returns were concentrated in certain areas.

2019 was the year of the mandie within the convertible universe. Mandatory convertible issuance surged and returns surpassed convertible bonds.

Mandatories saw returns of 22.1% compared to convertible bond returns of 19.8%, according to the Barclays report.

Utility companies are the largest issuers of mandatories and the equity of utility companies tend to outperform in a low rate environment, a market source said.

“Utilities are really correlated to rates, so when the Fed is in cut mode, utilities tend to do better,’ the source said.

Returns were also concentrated in certain names, with the performance of 20 issuers responsible for the lion’s share of the Bloomberg Barclays index returns.

Advanced Micro Devices Inc.’s 2.125% convertible notes due 2026, Microchip Technology Inc.’s 1.625% convertible notes due 2025 and 1.625% convertible notes due 2027 and Medicines Co.’s 2.5% convertible notes due 2022 and 3.5% convertible notes due 2024 drove the performance of the index.

A lot of accounts also made money off of Tesla Inc., a market source said. Some accounts placed big bets that Tesla would make good on the SolarCity Corp.’s 1.625% convertible notes which matured on Nov. 1 and were trading below par.

“There were some sleepless nights,” a market source said. But ultimately, those bets paid off.

While returns were good, the performance was driven by certain issuers. Market players that were not active in those names missed out.

While a pullback is expected in 2020 with returns sinking into the single digits, several factors make convertibles well suited to continue to outperform other asset classes.

The forecast

The forecast for returns is largely based on the outcome of several “known unknowns,” such as the U.S.-China trade war, the 2020 election and the future direction of monetary policy, according to the BofA Global Research Report “Year Ahead 2020: Out of chaos comes opportunity.”

While returns are not expected to come anywhere near 2019 levels, convertibles are well positioned for another strong year.

Barclays projects convertible market returns of 7% in 2020. However, if equities outperform, the market could see returns as high as 11.9%.

The BofA Global Research report pegged 2020 returns in the 8% to 10% range.

While valuations in equities are at all-time highs and BB credit spreads are broaching investment-grade levels, convertibles have bucked the trend.

Valuations in the universe are still reasonable, sources said.

“Valuations have gently trended towards moderation,” Krishna said. Krishna pointed to credit spreads between non-investment grade convertibles and the high-yield index. “Convertibles haven’t tightened as sharply,” Krishna said.

Valuations in the convertibles universe did not keep pace with credit markets, which may have been a result of more disciplined investors, significantly improved liquidity, or the basic fact that the convertibles universe is different.

The reasonable valuations in the universe have left room for future growth with some sources expecting continued gains in convertibles underlying equities and tightening credit spreads.

The downside

While convertibles are expected to again outperform other fixed income asset classes, there are several scenarios that could push returns into negative territory.

A pull back in equities could easily drag down the convertible universe and that pullback could happen with a single tweet, a market source said.

Some sources are expecting that pullback as part of the natural progression of the market. “This bull market is really long in the tooth,” one sources said.

Another source expressed surprise the market was at its current level.

With the convertible universe concentrated in the tech and health care sectors, investors are particularly vulnerable to the performance of those sectors.

The tech sector, in particular, has priced-in optimism about the resolution of the U.S.-China trade war, according to the BofA Global Research report.

If those talks break down in 2020, the tech sector will suffer.

The 2020 election is also a huge wildcard with investors expecting a pullback in health care if senator Elizabeth Warren (D-MA) is elected.

“Concentration risk will remain,” Krishna said. “It will put pressure on investors to be careful in how they are exposed to sectors.”

While recession chatter has abated and current forecasts are low, recession remains the most significant risk to the convertible market in 2020, according to the BofA report.

In a downside scenario, Barclays places returns at negative 3.5%.

The year ahead is full of unknowns. However, sources were in agreement about 2019 – it was a good year for the convertible market.

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