Highbridge outlook: Convertible debt opportunities
Systemic and cyclical trends present compelling opportunities for convertible debt investors who have capital to deploy
Jason Hempel, Jonathan Segal, co-Chief Investment Officers, Highbridge Capital Management
The sell-off in rates and equities – especially growth and health care stocks – combined with the convertible debt market’s supply side glut and investor base characteristics, has created a near-perfect storm.
Credit outlook: Opportunities in alternative convertible debt strategies
Convertible investment strategies can be an attractive, but often overlooked, source of uncorrelated returns. The complex nature of convertibles – which share characteristics of both debt and equity – offers potential pricing inefficiencies and arbitrage opportunities that can be utilized to potentially generate a portfolio with asymmetric returns. The pricing inefficiencies in the current market context are largely caused by longer-term issuer and investor-base trends. This effect is compounded in periods of extreme equity market stress, as a substantial portion of the convertible debt market investor base historically de-risks during these periods, creating a dislocation event and credit opportunity set. Today, a combination of recent convertible debt market issuance and sector skew has further exacerbated this dislocation, driving excessive downside credit/equity correlation. Ultimately, we believe these systemic and cyclical trends present compelling opportunities for convertible debt investors who have capital to deploy.
Systemic opportunity: Market composition trends limit competition
The U.S. convertible debt market is a relatively small and niche investment universe, comprising ~$240B across ~500 issuers.1 As illustrated below, more than 80% of the U.S. market is currently unrated and only 10% is investment grade, which limits the type and number of managers that can invest due to mandate restrictions.2 This lack of rating is not necessarily indicative of poor credit quality – as over 50% of U.S. convert issuers only have convertible debt on their balance sheets3 – but often rather a function of issue size (~80% of current U.S. convert issuers are small-cap or mid-cap companies),4 speed to market and sector bias.
U.S. convertible debt market: Breakdown by credit rating
Further, as shown in the chart below, since the 2008 financial crisis, the universe of convertible bond investors has shifted significantly from hedge funds (previously 75%) to long-only investors (now 55%), as challenging performance and investor outflows during the financial crisis forced many hedge funds to reduce their presence or close altogether.5 The hedge fund investors that remain tend to focus on trading volatility – relying primarily on quantitative tools to drive investment decisions – and are less comfortable with the credit risk of non-investment-grade issues. Meanwhile, long-only investors generally use converts as an equity substitute and often have guidelines that limit unrated holdings. These two groups of investors rely heavily on equity market valuations as a barometer for creditworthiness, often foregoing deep underwriting exercises.
U.S. convertible debt market: Investor base
As a result, the convertible debt market offers a systemic opportunity to seek idiosyncratic returns for investors who utilize a credit lens and capital structure arbitrage framework. To capitalize on this opportunity set, we believe trade structure should be driven by fundamental analysis and should leverage the inherent flexibility of convertible bonds to express a specific view on the relative value of the convertible bond – or one of its component parts – relative to other parts of the capital structure. Intra-capital structure hedges can be implemented to isolate attractive credit spreads or to participate in an undervalued equity, and default risk can be hedged with a short equity position. Further, broad market exposures, such as the risk of rising interest rates or widening credit spreads, may be hedged by the investor to isolate the desired idiosyncratic exposures.
Cyclical opportunity: Historic market dislocation
Record convertible bond issuance in 2020 and 2021, largely a response to the COVID-19 pandemic, included many highly valued issuers that have subsequently experienced material stock price declines. However, even for an arbitrageur, many hedged investments among this group have resulted in losses or did not prove profitable, despite large equity declines, as the instruments were too richly priced.
We believe this repricing of the convertible debt market has materially improved the opportunity set. Below we show the U.S. convertible debt index’s performance versus the index’s underlying equity performance, in addition to other key equity indices. As you can see, converts have not exhibited the asymmetry for which they are designed. Instead, they are moving in near lockstep with broader equity market performance and their bond floors have evaporated. This is clear in the charts below, which show that non-investment-grade convertible debt has seen material spread widening, whether assessed on an absolute basis or relative to high yield.
U.S. Convertible Index: Performance vs. equity indices
Non-investment-grade convertible debt spreads vs. high yield
The natural question is: what is driving this price action? On the one hand, inflationary pressure, margin compression and a risk-off mentality are drivers. On the other hand, we believe that there are identifiable technical factors and characteristics of the current convertible bond market that explain, at least in part, what we now witness:
Growth stage: Many convertible bond issuers are mid-cap and may consume cash, sometimes by design. Cash consumptive businesses are not bad per se, but there is typically market disdain for this profile when capital markets become more volatile.
Market growth: The convertible debt market has experienced explosive issuance over the past two years. The limited buyer base cannot absorb the amount of supply. Following the COVID-19 pandemic, this phenomenon kept the market cheaper for longer than otherwise would have been the case and is now driving a violent sell-off as many convertible debt “tourists” rush for the exit.
Share price declines: In our view, underlying equity declines have driven too much downside credit/equity correlation. The market’s overweight to technology and health care companies is a key culprit as well.
Investor losses: Investor losses, especially among long-only investors, have begun to feed upon themselves as evidenced by redemptions or fears of that reality.
To capitalize on this opportunity set, among the credit sensitive portion of the convertible debt universe, we believe that investors should focus on deep credit underwriting capabilities, trading acumen and quantitative trade structuring investment tools. Specifically, we believe convertible bonds possessing some of the following characteristics are attractive:
Attractive credit metrics, recovery attributes and/or liquidity runway
Short-dated maturities, forcing a pull-to-par impact
Identifiable price action catalysts
Instances when convertible debt is an issuer’s only interest-bearing obligation, increasing the probability of exchange transactions
Sufficient underlying market capitalization to facilitate equity issuance
The relative value characteristics of these investments are compelling, as they present an opportunity to neutralize equity risk via an intra-capital structure hedge, create an attractive recovery option and mitigate the substantial basis risk that typically exists in traditional long-short investing, as the short exposure is deliverable into its long investment.
Additionally, in periods of dislocation, the ability to combine credit experience with asymmetric securities, in a market in which few participants do so, presents an increased opportunity to execute corporate actions, such as exchange transactions (e.g., debt-for-debt or debt-for-equity), and may offer the potential to make attractive, longer-duration investments. Following the initial shock of market dislocation, many company boards and management teams tend to digest a new reality and, subsequently, seek to proactively – often in a private setting – address their financial needs. Such capital solutions are often not provided for by traditional sources of private credit nor hedge fund managers subject to liquidity constraints, creating an opportunity for those with both credit expertise and longer duration capital.
The sell-off in rates and equities – especially growth and health care stocks – combined with the convertible debt market’s supply side glut and investor base characteristics, has created a near-perfect storm. Convertible bonds allow for a multitude of trading strategies that create opportunities to exploit potential security mispricing and inefficiency. This recent dislocation has increased the opportunity to extract such inefficiencies. Furthermore, isolating and capturing pricing inefficiencies in these component parts can potentially provide idiosyncratic sources of risk and return. Such idiosyncratic risk/return streams typically have low correlation to each other as well as low correlation to other hedge fund strategies and asset classes. As a result, convertible strategies can potentially add attractive return and diversification benefits to a broader portfolio.