Outlook 2022: New convertible issues drag returns in 2021, create opportunities in 2022

By Abigail W. Adams

Portland, Me., Dec. 31 – Record heights for equities, record tights for credits, skyrocketing inflation, volatile Treasuries, retail traders, short-squeezes, China’s regulatory crackdown, the Federal Reserve – 2021 marked a turbulent year for the convertibles secondary market with fierce headwinds and tailwinds driving large profits and losses.

Exuberance was at its peak in the first quarter with the secondary space looking to extend gains from 2020 – one of the best years in the convertible bond market’s history.

While the exuberance resurfaced at various points in the year, it was squashed by sharp pullbacks in equities as investors priced in an end to pandemic-era stimulus and a normalization of monetary policy.

The high-momentum growth companies that drove new issuance in 2021 and secured some of the most aggressive pricing in the market’s history were particularly vulnerable to the downturn in equities and were among the largest drag on overall returns.

The increasingly large “ADR space” in the convertibles universe also bled as investors fled the equity of China-based companies amid Beijing’s regulatory crackdown and delisting threats.

While the convertibles market is closing 2021 well off the highs of the year, it remains in positive territory.

Returns are expected to remain in the low single digits in 2022 – a far cry from 2020 but still competitive with other asset classes.

However, the underperformers this past year are presenting interesting opportunities that could drive returns in the future.

A turbulent year

It was a turbulent year in the convertibles secondary market with exuberance high in the first quarter as equity benchmarks consistently set, then broke records.

The new deal pipeline was strong as high-momentum growth companies stampeded to price convertible notes amid equity and credit conditions that enabled the preponderance of the No-No, 0% convertible bonds that price at par.

However, the exuberance was doused as the year progressed and potential headwinds for the market, which were identified in 2020, came to fruition.

The rotation to value stocks from growth stocks, rising rates, and crumbling equity valuations hit the convertibles secondary space hard.

The market got a taste of the pullbacks that were in January with the GameStop short-squeeze sparking a sell-off in equities as investors began to question equity valuations.

However, the convertibles market got a true taste of the pressure growth stocks would feel in a higher rate environment in late March when the 10-year Treasury yield topped 1.778%.

Speculation about a hawkish shift in the Federal Reserve’s monetary policy caused enormous gyrations in equities as benchmarks sold off, recovered, broke out to new heights, and sold off again.

Despite the gyrations throughout the year, the secondary space was on firm footing at the end of November with positive third-quarter earnings and an overshoot in estimations about rising interest rates again supporting a bull run.

Outright convertible returns stood at 9.9% in late November, according to the BofA Global Research report “Global Convertibles Year Ahead 2022: The best of what’s around.”

The HFRX Convertible Arbitrage index posted year-to-date returns of 8.16% at the end of November.

Then came the hawkish pivot in monetary policy market players had speculated about for the past year.

Federal Reserve chair Jerome Powell announced an end to the use of the word transitory to describe skyrocketing inflation figures in early December.

The Federal Reserve announced at the conclusion of its mid-December meeting an acceleration of bond tapering and penciled in three rate increases in the coming year.

The already pressured equities of high-growth convertible issuers went into a tailspin.

DigitalOcean Inc. priced a $1.3 billion issue of 0% convertible bonds due 2026 on Nov. 15 at par versus a closing stock price of $119.01.

On Dec. 17, DigitalOcean’s 0% convertible notes were changing hands at 86.25 versus a stock price of $73.33.

Outright convertible returns stood at 3.8% as of Dec. 10, according to the Barclays report “Grinding Higher: U.S. Convertibles Outlook 2022.”

HFRX Convertible Arbitrage index returns had fallen to 3.5%.

No-Nos, “were a major drag on returns,” said Michael Youngworth, BofA Head of Global Convertible Bond Strategy and author of the report “Global Convertibles Year Ahead 2022.”

“The combination of underlying equity deterioration and the 0% coupon bond floor led to large losses in those names,” Youngworth said.

Approximately 60% of the deals to price in 2021 were delivering negative year-to-date returns, according to the Barclays report.

No-Nos accounted for $37.5 billion or 42% of total new deal volume in 2021.

“The market had become flooded with names from high-growth borrowers that were heavily subject to rising rates due to not only their aggressive structures but also their lofty equity valuations – a troublesome combination for an abrupt rise in yields,” Youngworth wrote in the BofA report.

Beijing’s regulatory crackdown on private industry and delisting threats also caused pain for the secondary market as investors fled the equities of China-based companies.

Turbulence is expected to continue in the coming year as risk assets continue to grapple with a higher-rate environment.

However, while returns are expected in the mid-to-low single digits, the convertibles market will continue to be competitive with other fixed income classes.

Return expectations

The turbulence of 2021 is expected to continue in the coming year as the convertibles market grapples with its increased exposure to rising rates.

Growth names currently account for 52% of the total domestic convertibles market with the median PE ratio for convertibles issuers 28, according to the BofA report.

Barclays estimates that convertible underlying equities have 60% growth exposure and 40% value exposure.

However, there is a limit to the damage that will be inflicted on the convertibles market in a higher rate environment.

“If rates increase, the 0s will be negatively impacted the most,” said Venu Krishna, Barclays analyst and co-author of the report “Grinding Higher.”

“However, if the whole [Treasury] curve goes up 100 bps, the convert market will lose around 1 5/8 points by our estimate,” Krishna said.

The scenario is extreme and improbable.

While high-multiple, growth stocks will remain vulnerable in the coming year, returns are expected to be positive.

BofA is projecting returns of 4% to 6% in 2022.

Barclays anticipates returns of 5.2% in their base case scenario, 7.5% in their upside scenario and 2.4% in their downside scenario.

There is the possibility for some added value through tightening credit spreads and increased volatility.

Non-investment grade convertible notes are lagging the high-yield B index, raising the possibility of spread tightening, according to the Barclays report.

However, equities will remain the primary drivers of convertible returns.

“Return expectations are in the high single digits, mainly because we expect earnings growth to be robust, but we do expect multiples to contract further,” Krishna said.

While a far cry from the 50% returns the convertibles market boasted in 2020, returns will remain competitive with other fixed income asset classes.

Estimates for returns in the high-yield market range from 0.6% to 5%.

The beaten down convertible notes of 2021 will also present some interesting opportunities in the coming year with the major losers of 2021 a possible driver of returns in the coming year.

Attractive opportunities

There were lots of “grown men crying in their coffee” due to the performance of some convertible notes in 2021, a source said.

However, some of the issues that led losses in 2021 may be a potential source of returns in the coming year.

“From a valuation perspective, some of these names are starting to look attractive,” Youngworth said. “A lot of them have traded down to their bond floor. When there is little concern for their credit risk, it creates an attractive opportunity.”

Peloton Interactive Inc.’s 0% convertible notes due 2026 were among the new issues that dragged returns in 2021 as the pandemic-era darling dealt with equipment recalls, slowing growth projections and various other public relations disasters.

The notes were delivering negative year-to-date returns of 19.8%, according to the BofA report.

However, the convertible notes, which were trading on an 85-handle in mid-November, were trading 6.3% cheap.

While the beaten-down convertible notes of 2021 were beginning to look attractive, the names remain divisive.

“Some people think there is a ton of upside; some think they’re not going anywhere,” Youngworth said. “But from a valuation perspective, the entry points look good.”

Several issues from China-based companies were also offering attractive entry points.

VNET Group, Inc.’s (formerly 21Vianet Group Inc.) 0% convertible notes due 2026 delivered year-to-date returns of negative 21.3% as of mid-November with the notes trading at 81, according to the BofA report.

However, they looked 11.3% cheap.

DiDi Global Inc.’s announcement that it would delist in late November added further pressure to the convertible notes of China-based companies, the majority of which trade now below par.

However, most convertible notes indentures have a clause that enables a par put on a delisting event, increasing the attractiveness of some of the notes.

Whether the convertible notes indentures will be honored upon a delisting event, “is the question,” a source said.

There may be further downside for the convertible notes of high-growth names and China-based companies in the new year.

However, “the underperformance of some convertibles in 2021 does create potential opportunity,” Krishna said. “That’s where active management and fundamental work start coming in.”

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