Global convertible security issuance ramped up during the third quarter, with $22.6 billion coming to market. Year-to-date issuance stands at $60.8 billion, now generally on pace with 2015. We expect healthy issuance to continue even in an environment of subdued growth.
With many so-called “safety stocks” and traditional fixed income securities trading at stretched valuations, investors are facing more downside volatility. Because convertibles provide the opportunity for upside equity participation with less exposure to downside volatility, we believe they can offer a compelling alternative to holding more richly valued defensive equities. Active management remains key, given that underlying valuations are bifurcated, with traditional value areas trading at elevated levels versus traditional growth areas.
In our positioning, we continue to emphasize the balanced portion of the convertible market and are more selective regarding the most equity-sensitive and the most speculative issues. From a sector standpoint, we continue to favor technology—valuations are fair, fundamentals are strong, balance sheets are solid, M&A activity is robust, and secular trends provide tailwinds. We are underweight in cyclical areas (industrials, energy, materials) but are monitoring potential OPEC actions that could have positive impacts on the energy sector. The global search for income has resulted in full valuations for many yield-oriented “bond surrogates,” but we have identified opportunities in REITs, long-duration bank-issued convertible preferreds, and utilities.
As we discussed in our monthly high yield commentary (read here), higher energy prices, a patient Federal Reserve and a declining default rate have spurred investor appetite for high yield debt. However, despite strong technical demand, we see increased risks.
The recent surge in issuance suggests the capital markets are open to all but the riskiest issuers. We are concerned the market is pricing these riskier deals at aggressive levels relative to years past. Also, the average coupon for the overall high yield market has dropped over the years, giving investors less cushion when interest rates rise and/or spreads widen.
In this environment, we remain overweight industries that we believe can still generate solid fundamentals absent a robust U.S. economy, and underweight those industries that are more secularly challenged. We are highly selective toward the most speculative credits, choosing instead to focus on “rising stars” (high yield issuers that we believe the rating agencies will upgrade to investment grade in the near term). Historically, pinpointing these opportunities before the agencies has proven to be a significant source of alpha.
Brexit and the market response to it remind investors to be prepared for both unexpected events as well as unexpected market reactions. The referendum in favor of leaving the EU took many by surprise, but so too did the short-lived market selloff and rally that followed. Now, eyes are on the U.S. presidential election. We cannot predict with certainty the outcome, the market’s immediate response, or the changes to fiscal policy that will unfold over the months to come.
Moreover, the U.S. elections are only one of many events on the horizon—we also have central bank policy decisions, Brexit and a variety of referendums and elections in Europe. However, history has shown that emotional responses increase the likelihood of being whipsawed. Accordingly, we encourage investors to maintain a disciplined, long-term focus through these next months.