Like high-yield bonds, convertible bonds are closely correlated to equities. However, Michael Reed argues that convertible bonds may be a better way to play the equity market in 2014.
"High-yield bonds will still post positive returns in 2014, but if you have a 5% coupon and a 50-basis-point rise in interest rates, you will struggle to earn that coupon," says Michael Reed, a senior portfolio manager at London-based BlueBay Asset Management LLP. He oversees the $704-million BlueBay Global Convertible Bond (Canada), one of the RBC families of funds. BlueBay Asset Management is a subsidiary of Royal Bank of Canada.
Convertible bonds are hybrid products, since they are corporate bonds with an embedded equity option. The latter attribute allows them to benefit both from strong equity markets and so-called credit-spread compression. That was the case in 2013, and Reed believes it should continue in 2014. "Equity markets will be supported by earnings-yield measures, in that earnings are coming through to support valuation levels."
The global market for convertible bonds accounts for about US$500 billion in assets. Moreover, many convertibles are investment-grade and issued by household names such as Intel and Microsoft. "People think they can invest only in high-risk issuers. That is not the case," says Reed. "You can buy a basket of very high-grade names on a global basis in the convertible-bond market."
Running a portfolio with about 160 names, Reed has allocated the bulk of the fund to developed markets and about 30% to emerging markets. The latter is double the weighting in the benchmark UBS Global Convertible Focus Index (Hedged to C$). From a credit perspective, about 20% was recently held in A-rated issuers, 15% in BBB issuers, 40% in BB issuers and 20% in B-rated issuers. The fund's duration is about 3.9 years and single holdings are limited to about 3% of fund assets.
Reed cites relative valuations in justifying his emerging-markets allocation. "On the basis of equivalent ranking credits, you get paid a considerable premium to hold the credit risk on emerging-markets corporate bonds," he says. "At the same time, emerging-markets equities trade at a large discount to developed markets. That's what you are looking for: twin drivers of returns. That's why we are overweight there."
Michael Reed | |
A native of Sawbridgeworth, England, Reed is an engineer by profession who ended up a specialist in convertible-bond trading. "I was very keen on cars and worked briefly as a trainee design engineer for Ford Motor Co.," recalls Reed, who graduated from the University of Southampton in 1989.
"But I wanted to work in a more rewarding environment," he says. "The derivatives world was expanding rapidly in the UK, and I was able to use my mathematical ability."
Reed joined Salomon Brothers, trained partly in New York and returned to London where he worked on the Japanese warrant-trading team. He traded options on Japanese stocks and was also involved in arbitrage. In 1991, he was transferred to Tokyo where he managed the firm's Japanese warrant arbitrage book.
In 1993, back in London, Reed conducted proprietary trading on options and warrants. The following year, he took over the European convertible operation. Between 1995 and 1996, he managed the Japanese and Asian convertible-bond desk. In 2000, he was appointed managing director.
In 2002, Reed joined Pendragon Capital, where as a partner he ran a US$400-million convertible hedge fund. In 2007, Reed was hired by BlueBay and conducted long-only investment management. BlueBay manages about US$3.2 billion in global convertible bonds.
Launched in November 2012, BlueBay Global Convertible Bond returned 11% for the 12 months ended Feb. 28, versus 5.6% for the median fund in the High Yield Fixed Income category. However, Reed says the fund is Canada's only convertible-bond fund and differs considerably from its peers.
To choose from his universe of about 2,000 securities, Reed takes a top-down view to determine which sectors, geographic regions and credit profiles look attractive. A team of analysts examines the fundamentals of potential companies and the type of credit. "For example, if we are looking at lower-rated companies, we are looking for credit-tightening potential, not equity potential."
The fund is diversified across several sectors, although Reed has a bias to software and information-technology providers, which account for about 15% of the portfolio. One representative name is Salesforce.com Inc. CRM, a San Francisco-based cloud-computing firm that specializes in customer-relationship management services and is benefitting from the growth in outsourcing.
Some investors may be skeptical of Salesforce.com's triple-digit price-earnings multiple, but Reed believes that convertibles are an ideal way to play the stock. "You have the exposure to the upside, which is unlimited with convertibles. But if the equity de-rates, or if the market de-rates, you are protected because you have the fixed-income element."
Looking ahead, Reed expects equity markets to rise about 10% in 2014, and credit conditions to tighten as long-term interest rates rise. "In this environment, high-yield bond funds will return about 4% to 5%, before fees. But convertible bonds can deliver 7% to 9%."