Comment: Market risk could lead to another leap in convertible bond issuance

Convertible bond issuance hit a record year in 2020, with more companies than ever seeking an alternative form of financing in the wake of the 2020 stock market crash. This was particularly notable in April-June as firms made strategic funding decisions using alternative financing methods. By Justin Craib-Cox

Source: Bloomberg, 29 December 2020

While we don't envisage another big crash like that seen in 2020, we are still in a world of rising volatility and there are a number of areas that could still send chills through the market and lead to another spike in convertible bond issuance in 2021.

The rollout of vaccines is going well in some areas and less well in others and a possibility of containment of Covid-19 infections is giving hope that life could go back to normal sooner than previously thought. We are in a very different environment to last March; fear took over, leading to a short and very sharp sell-off in markets. It is unlikely to happen a second time round, but a correction is certainly possible. Markets have roared back since the lows, but there remain many questions about when the world might return to some form of normalcy.

There may be unpleasant surprises in the forms of new coronavirus variations, persistent need for rolling lockdowns, or an uptick in inflation that would mean capital losses for bonds. Amidst this backdrop, volatility is going to stay higher than it has been for the last five years, at least for the foreseeable future.

For convertible holders, a correction in stock prices might hurt, but perhaps not as much as in other asset classes. By that, we mean that if conversion option loses value, most issuers can still repay their bonds, which insulates losses.

Equity investors could fall much further if lofty growth aspirations do not come to fruition, and credit investors have little cushion against either the impact of greater-than-expected defaults or inflation. We also see that convertibles have proved their value to issuers in times of stress, and the record amounts of primary market activity that we saw in 2020 could well continue.

It feels like to a certain extent there is a disconnect between economic realities, markets, and the mood of the person on the street. This kind of disparity can lead to blind spots and we have identified a number of areas of uncertainty still plaguing markets that we believe may drive more firms to seek alternative financing in 2021.

1. Fear of the unknown
If further coronavirus restrictions are needed than is currently priced in to markets, then firms could find themselves again in need of capital to survive. For example, all bets are still off in sectors such as travel.

Fear of the unknown is a powerful sentiment driver and without a good understanding of the market the tendency for a ‘sell first, ask questions later' mentality sets in when you have less influence or understanding of it. Markets could be given to bouts of nervousness based on a lack of understanding of these areas.

2. Irreversible trends
Home working has been one of the big shifts of the pandemic. Office space may never recover and the impacts of that have not necessarily been fully felt. If people don't come back to urban centres to work in a meaningful way, how does that change the economies of global cities like London?

Understanding the impact of these trends has been somewhat masked by the performance of closely watched firms like Amazon where these trends have been positive or had little effect - but there is a large segment of the economy unaccounted for by markets, which hasn't prospered from the change. This downside seems to be forgotten readily.

3. Negative rates
Predicting the impact of possible negative rates is incredibly hard to do. The Bank of England has given banking institutions six months to prepare.

Then what is the next step after that? The unknowns caused by moving the economy to negative rates are enormous, and how bond markets in particular would react is hard to judge.

4. Excessive valuations
There's a lot of argument over whether certain sectors and companies are in a bubble. While you can argue whether they are or not - what is clear is there is a lot of excess liquidity trying to find a home, and this is driving up valuations in areas where the outlook might not be that clear. They're not necessarily inherently risky, but the level of unknowns at the moment is high.

Justin Craib-Cox is co-manager of the RWC Sustainable Convertibles fund