A debt crisis in Europe, coupled with a US debt rating downgrade in the midst of an economic slowdown … summer 2011 will be remembered as a period of stock market panic with equity indices plummeting (the CAC 40 was down as much as 23% over one month). Many stocks have therefore now been oversold, pricing-in a recession in the western world and trading on very cheap multiples (PE, Price to book…). Equities have been marked down across the board, indiscriminately.

Outlook is still positive however for many European companies which generate most of their business outside of the region. Furthermore, equity market dividend yield cannot be overlooked when compared to French or US government bonds. There are nonetheless still some very real risks: the European debt issue is far from settled and economic indicators show that the global economy is slowing down.

In this context, convertibles therefore appear to be the best-adapted investment vehicle to capitalise on a stock market rally whilst limiting downside if markets continue to fall (on average, convertibles capture 2/3 of upside and only 1/3 of downside). In addition, they are now at cheap levels again (unlike at the beginning of the year). Convertibles are trading at a discount to straight bonds (150 bp) and are also discounted in terms of volatility (up to a 20% spread vs. short-dated options in some cases).

Convertible - EUROPE

Convertible - US

We are not expecting another convertible crash like in 2008. The profile of the convertible bond-holder base has changed radically and the vast majority of the market is now held by long-only funds (e.g. Pimco) whereas in 2008 highly-leveraged hedge funds were the main holders. Furthermore, over the past two years, most companies have overhauled their balance sheets through new issuance, or deployed Cash Flow to reduce debt … It would appear that there is no interbank liquidity crisis for the time being. In contrast to 2009, banks have shored up their balance sheets and also now have access to the ECB liquidity facility. Corporate balance sheets have now been restructured.

Therefore, in the current environment, which is still rife with uncertainty but in which many stocks are deeply discounted, convertibles provide a good trade-off as a means to benefit from a market rally, especially as convertibles sometimes stage a recovery ahead of equity markets. We believe that the appropriate strategy at the moment is to maintain positions and, where possible, to capitalise on current lows to increase holdings.

Ainsi, dans l’environnement actuel toujours chargé en incertitudes mais offrant des décotes importantes sur un grand nombre de valeurs, les convertibles offrent un bon compromis pour bénéficier d’un rebond du marché, d’autant que les convertibles rebondissent parfois avant le marché actions. Il nous semble encore plus opportun aujourd’hui de conserver ses positions et, dans la mesure du possible, de profiter de points bas actuels pour les renforcer.