SSGA-SPDR: Check your deltas versus the delta variant

8 juli 2021

Reflation, reopening and a bit of stress on long-duration assets created a bumpy road for fixed income in the first half of 2021. While the coronavirus delta variant has cast a shadow on sentiment, the market has remained fairly resilient and our outlook is still optimistic – although with a kernel of caution, as our Global Market Outlook suggests.

In this context, we revisit the case for convertible bonds as one of the potential investments to navigate the next phase of the rate cycle (belly-led small bear flattening?).

The key questions for investors as we enter the summer are: what is the potential impact of the Delta variant on the reopening trend, and what can we expect in terms of inflation and monetary policy?

All in all, these uncertainties present a potentially volatile combination but there is still cause for a positive outlook.

Convertible bonds as a hedge against volatility

Historically, convertible bonds and high yield tend to outperform other segments of the fixed income market during recovery and expansion cycles. We have seen this trend confirmed so far in 2021, with the trio of 0-5 US high yield (3.9%), European high yield (2.9%) and global convertible bonds (3.3%) being among the few positive performers in the first half of the year.

If that positive trend continues, as PMI indicators indicate, the pro-risk stance could support spread harvesting and risk-on trades. Long-duration government bonds were among the worst performers along with emerging market debt local currency, which suffered because of the stronger dollar.

Moving to the next phase of the rate cycle?

Where are we in the rate cycle? We might be past the violent steepening phase of recovery pricing (partially led by inflation) and we could be moving to the next phase where curves may continue to gradually flatten with volatility falling and shifting towards the belly of the curve relative to the long end.

In the meantime, the US Federal Reserve (FED) has started moving a little more overtly to a tightening bias, which has driven inflation expectations lower (10-year US breakevens fell quite a bit from their mid May 2.56% peak to 2.24% in mid June). In parallel, the still-growing Fed balance sheets could continue to support the Treasury market, albeit less from a flow and more from a stock perspective.

Convertible bond performance

Global convertible bonds exhibit an interesting balance between growth and protection not only thanks to their hybrid nature but also through their balanced exposure between growth in technology and more value exposures in banking and consumer discretionary.

While airlines and resorts performed well in the first half of 2021, the respite was a bit challenged by the overall yield moves in June. Utilities and certain large names, such as Tesla, within Consumer Discretionary weighed on sector performance.

How to position for the summer?

Deltas vary by region, with Europe still being more prone to a 'hybrid' and 'value' bias while US exposures are closer to equities with an average delta. The fall of the technology sector in May, in particular, has provided better entry points for the US market and helped the recovery in June.

Valuations in this market have positioned convertible bonds to potentially benefit from continued strong performance of the US economy while partially protecting against clouds that could arise from the Delta variant. As we have seen in the UK, this new variant has delayed a fuller reopening by a month and continued to hinder citizens’ ability to travel.

Lastly, the robust new issuance of more than $ 90 billion so far in 2021 has helped increase the universe's diversification. At the same time, certain high delta and large names in the universe, such as Tesla, have gradually diminished their influence on performance, falling from the maximum of 4% going into 2021 to c. 1.25% as of quarter end.

This followed a bond maturing in March 2021 and the reduction in the outstanding amount of the March 2022 bond to below index inclusion levels. The May 2024 bond remains the last convertible in the universe and is expected to be a lesser driver of performance volatility going forward, even more so as the remaining outstanding amount continues to reduce.

As volatility has fallen back to the mid 10s (VIX was 15.4 as of 1 July 2021, according to Bloomberg Finance L.P.), convertible bonds can offer a relatively attractive way to gain exposure to the continuation of the recovery while partially hedged to a deterioration of sentiment in the summer. Still the best of both worlds? Hopefully the best of two summer months.