Brice Perin, fund manager at Generali Investments, in charge of GIS Absolute Return Convertible Bond Fund, explains in this interview with Funds Society why it is worthy to use an absolute return strategy in convertible bonds.
What do convertible bonds bring in an environment like the current one?
At Generali Investments we believe that convertible bonds feature an attractive asymmetry between credit and equities, especially in a volatile, uncertain market.
The securities’ hybrid profile automatically adapts to market movements in order to capture on average 2/3 of the market’s upside and limit to 1/3 of the drawdown. In fact, in falling stock markets, the securities automatically lower their equity sensitivity, therefore getting closer to the bond floor.
In addition, we are convinced that introducing a flexible absolute return approach enhances this embedded convex profile, therefore further limiting drawdowns and aiming to capture the market’s upside.
One of the key needs today is true diversification and decorrelation with other asset classes: can your fund accomplish this challenge?
Yes. In fact, convertible bonds combine various alpha drivers such as equities, bonds, credit, implied volatility, ratchet/prospectus clause, and benefit from different market cycles. These components do not always move together at the same time: depending on the market cycle, some would generate alpha while others could underperform and undermine performance. To optimize the different parameters, we have the ability to hedge partially or totally the unwanted parameters, in order to focus on the ones we would like to isolate and benefit from.
How is the absolute return strategy obtained with convertibles?
An absolute return investment approach applied to convertible bonds fund allows us to add arbitrage techniques in a transparent, rigorous and risk-managed UCITS structure. The GIS Absolute Return Convertible Bond fund aims at generating alpha through from both outright «credit» and «equity» exposure offered by our convertible bonds’ long positions and via hedging strategies (which isolate specific alpha creating components) – whether it is a macro hedge, overlay or a micro hedge at the security level. Moreover, those techniques aim to improve the convexity of convertible portfolios and the downside protection offered. Put simply, the concept is based on isolating and exploiting a desired parameter, for example isolating an attractive prospectus (“ratchet”) clause – while limiting or removing the unwanted underlying equity exposure.
What are your objectives in terms of returns and volatility?
Our strategy has an absolute return objective of achieving consistent performance across the market cycle, with a target volatility of 6-7%.
What strategies are applied in convertible bonds in general and specifically in your fund ? Arbitrage strategies, volatility … How do they work ?
Besides the standard outright exposure that convertible bond funds offer (mainly directional exposure on underlying equity and credit), implementing an absolute return philosophy within this asset class allows us to introduce some additional arbitrage and hedge strategies.
The latter consist of hedging partially or totally some of the risks, in order to focus only on some of the convertible bond parameters. As an example, we can hedge the underlying equity risk in order to isolate and implement volatility or prospectus strategies.
When implementing a volatility strategy we aim to benefit from the favorable changes in the implied volatility of a convertible bond, or from the favorable change of the spread between CB implied volatility and realized of the underlying equity. By re-adjusting our underlying equity hedges, we “capture” underlying equities’ volatilities.
Whilst, when investing and isolating the prospectus clause, we aim to benefit from, for example, some issuance premium compensation provided in the case of a takeover (that could be undermined by equity performance if un-hedged). Lastly, we can also decide to adjust the fund’s global sensitivities to equity or credit markets via overlay index positions to limit market drawdowns.
Is it easier to achieve absolute returns with convertibles than with other asset classes? Or more difficult? Why?
The current tumultuous market conditions and uncertainties make it challenging to achieve absolute returns across all asset classes. The heightened volatility and the frequent periods of strong underperformance in global markets (November 2015 to February 2016) enhance the importance of adopting a flexible and benchmark agnostic investment approach.
As mentioned before, convertible bonds carry a hybrid and asymmetric profile which adapts naturally to market movements. In fact the equity exposure (sensitivity or delta) moves in line with the equity markets therefore moving converts closer to their bond floor in periods of sell-off or to more equity-like profiles during market upsides and rebounds. From this perspective we consider convertible bonds have self-adjusting features.
In addition, convertible bonds associate other components such as volatility and prospectus (ratchet) clauses. Being able to isolate these, in order to hedge or invest in each component, allows us to identify the sources of alpha and eliminate partially or completely the underperforming components.
For all of the above arguments we believe that the asset class gives more leeway and opportunities to achieve total returns over the market cycle.
When did the strategy was launched and how it has worked in bullish and bearish periods ?
The fund was launched early 2004 as an outright convertible bond strategy; therefore it has a long track record of over 12 years. In 2015 we thought of revamping the investment approach in order to be able to benefit from more sources of alpha and better navigate across all market cycles. From September 2015 we introduced some hedging and overlay strategies with an unconstrained and flexible investment philosophy. In 2015 the fund posted an absolute performance net of fees of 5.82% for a realized volatility of 5.12%.
Since last September we have experienced some extremely distressed market conditions, with some of the main underlying equity markets losing more than 20% at some point between November and February.
Nonetheless the fund outperformed the convertible and equity markets, as well as the peer group. In fact the fund has realized positive absolute performances since the reshuffle, thanks to an active delta management (mainly via futures and a few contract for difference single name positions) and a rigorous liquidity and credit analysis resulting in a cash portfolio of majorly mainly robust credit names.
Lastly, we have implemented an active risk process and improved our downside risk management, both at the front office and risk management level. Such a process consists of definition of maximum acceptable loss, de-risking mechanisms (implemented with various levels of escalations triggers) and re-risking (activated by loss recovery).
Can the current actions of the ECB help your strategy and fund ?
We believe that the latest ECB intervention will impact the European markets positively. On the credit side it will support valuations within the investment grade space and in certain riskier credit sectors. On the equity side we believe that market volatility could temporarily ease which would also impact on the underlying.
All in all, while we do not think that the recent ECB actions will have a direct impact on convertible bonds, we nonetheless believe that in the short run it will positively benefit the underlying asset classes (i.e. credit and equity), as was the case in the past weeks. This shall also benefit our convertible bond strategies both outright and absolute return. Having said that, should volatility surge again, our absolute return strategy should fully benefit from it.
Por Alicia Miguel Serrano