May 2021

Yields on longer-dated treasury bonds rose sharply over the past year, igniting investor concerns about the impact of rising rates on fixed income returns. The absolute level of yield on the 10-year treasury has historically been the best predictor of 10-year forward returns on fixed income, which makes it difficult for allocators to meet their return goals. In the short run, the path for rates seems headed higher fueled by vaccination driven reopening, and monetary and fiscal stimulus. This is happening at a time when credit spreads in high yield securities have compressed to record lows, while investors chase yield and illiquid assets, amidst a highly stimulatory monetary policy and a sea of liquidity. Given the still low levels of yields and spreads, near term fixed income return distribution is likely to be more skewed to the downside, more so in the treasury complex, but also to some extent in high yield, as there is very little room for spread compression to offset rising yields. This challenges the role of fixed income as a diversifier to equities in asset allocation. Given that the outlook for absolute returns from fixed income over the next decade is challenging, investors need to explore alternative solutions in order to reach return targets, while mitigating multiple risk components.

An allocation to low volatility strategies has been a key component for helping to reduce the overall risk levels of a portfolio. They have reduced the overall risk metrics of a portfolio by helping to limit, in some cases, the downside risk during down markets. However, they suffer from a large disadvantage when compared to convertibles. Low volatility strategies have not demonstrated the ability to participate in the upside during periods of strong market rebounds and/or exceptional market conditions such as those seen since the start of the 2020 pandemic.

Convertible issuance set a new record in 2020 with $113.7 billion of new issuance. The surge in issuance can be attributed primarily to growth sectors, such as Tech and Healthcare, and a significant number of issuers from recovery companies, primarily in the Consumer Discretionary sector, many of which were negatively impacted by the Covid-19 crisis. Sector and issuer composition has significantly broadened the investible landscape, especially as we enter an economic recovery. While we expect 2021 issuance to remain strong, the pace will likely moderate as market conditions normalize over the year. We believe issuance supply will be supported by the sharp earnings rebound from a cyclical recovery, healthy equity valuations, increased issuer capital spending, attractive pricing, and the presence of several large issuers. In addition, since there is still uncertainty on the timeline of normalization, we believe issuers will utilize Convertibles as a low-cost source of new capital to address any potential liquidity events and for liquidity insurance purposes.

The convex nature and low duration characteristics of Convertibles provide an improved risk/reward profile to the underlying equities, with more enhanced downside protection than common equity positions, and less interest rate risk than most other fixed income investments. This allows for a different outcome as market volatility increases, if we should experience a significant downturn in the market, or if rates adjust. Meaningful gains were booked in 2020 through the bonds that were exchanged/converted, while new issuance resupplied the momentum of the asset class with a wide breadth of balanced new issues. This natural conversion of securities combined with maturing issues removes downside risk to some equity-like issues in the market. For example, a portion of the outstanding Tesla issues have been converted in 2020, while one Tesla issue matures in March of 2021.