Invest Better with Convertible Bonds

Our next speaker tonight is Nick Berry from Pure Asset Management.

His presentation topic is Invest Better with Convertible Bonds.

Pure Asset Management is a boutique asset manager targeting double-digit returns.

They provide micro and small-cat companies with access to growth capital in the form of convertible debt equity instruments.

Their unique strategy is to invest in self-originated convertible bonds in ASX smaller companies.

Nick is a co-founder and portfolio manager of Pure Asset Management.

He has significant financial market experience in debt and equity.

He previously worked in ABN Amro.

Nomura and Petro Capital.

Nick lives in Northern New South Wales with his wife and two beautiful boys and hopes to one day learn how to serve without falling off.

Welcome to our presentation, Nick.

Over to you.

Great, and thanks very much for having me.

It's great to be here.

So today we're talking about convertible bonds and you can see the title here, get paid to wait for the small cap investing.

Now, please take a moment to read this disclaimer in your own time.

But first to lay out the landscape on why convertible bonds are a better way to have a risk-adjusted investment into equity exposure, we need to touch on the compounding underperformance of small caps in recent times.

So what this chart shows is the S&P ASX small odds performance versus the S&P ASX 100.

And you can see that currently the index is underperforming, the small cap index is underperforming by about 21%.

But also that underperformance has been widening progressively over time.

Now, there are a number of reasons for this.

So we are seeing a liquidity squeeze in the market where central banks increasing interest rates and taking money out of the system has forced people, I guess, to more safe haven larger cap stocks.

There is a flight to perceived safety taking into consideration the cost inflation risks that are out in the world right now.

the interest rate rising risks, the geopolitical risks, all of these things see investors tend to move to larger market cap stocks than small on the basis of perceived safety.

Cost inflation, as I mentioned, though, is a very key part of this because generally there is a perception that larger companies are better capitalised to weather cost inflation storms.

and typically a better place to be able to pass through the impact of cost increases in their pricing than perhaps smaller companies are in their less developed footing that they're starting from.

But then also what this underperformance of small caps versus larger caps has led to is a higher cost of capital environment for smaller company stocks.

The cost of equity has increased drastically for them.

But what you may not know is that this period of underperformance of small caps versus large caps is now worse than back at the GFC.

The green line on this chart shows that we had about 20 to 21 weeks of underperformance of the small cap versus the large cap index until that relative underperformance really started to tighten up quite aggressively.

But here we are today, well over 50 weeks of underperformance of the small odds versus the ASX100.

And that under performance is just continuing to get worse.

But markets are cyclical and will turn again.

I really love this chart.

I think it demonstrates the point perfectly, so the light green bars are showing periods of small cap under performance.

The dark green bars are showing periods of small cap out performance versus the large cap, and so you can see where you know we're entrenched in a in a fairly healthy period of under performance at the moment, but regularly this turns.

The key point to take away from this chart is that inflection point from the light grain bars to the dark grain.

It really happens over a period of one or two or three months.

So when the outperformance of large caps switches back to outperformance of small caps, it can happen very quickly.

But as we know, timing reversion is extremely hard and if you try to invest on that basis, more often than not, you're going to get caught.

So the question is, is there a way that we can recognise that valuations of small cap stocks are attractive, gain exposure to the potential for capital gains from here for when the relative performance switches back the other way, but without taking near term equity price risk on small caps?

And the answer is yes, that is convertible bonds.

So convertible bonds are a better risk adjusted way to invest in small cap equities.

So we've got an example here in 2008, Warren Buffett recapitalized Goldman Sachs with a convertible facility.

What Buffett saw in Goldman Sachs was a wounded athlete that still had near-term equity price risk, but a strong foundation for future value growth and an ability to pay a coupon whilst the equity recovered.

Why did he choose a convertible to do it?

Well, it was unclear what the timing was going to be

around when the equity price for Goldman Sachs would start to recover, but where the equity price had fallen to was now an attractive entry point to consider.

So the convertible bond allowed Buffett to take a secured exposure to Goldman Sachs, get paid a 10% coupon whilst waiting for the equity price to recover and to lock in a low conversion price that the debt could be switched to equity via

once the shares had recovered.

So in this example they locked in a conversion price of $115 a share when Goldman Sachs was trading at $87 and today it's at $327 a share.

So overall a very profitable trade.

Why does it work like this?

Well, convertible bonds are an interesting instrument.

They typically start out as debt, senior secured or subordinate secured and have the ability to convert to equity at a point in the future.

So when equity markets are under pressure.

The instrument tends to act more like a bond, so secured limited drawdown risk on the capital provided the health of the credit is there and then you're getting a regular income from a coupon being paid.

When equity markets are performing well, the instrument tends to act more like equity, enabling you to participate in capital gains and offering an alternative liquidity option to the debt being repaid by the company.

in the sense that you can convert to equity and then realise the position in the market.

So really it's got the best of both worlds as a trading instrument.

And then if we think about the characteristics of Australia's small cap market today, well, we've absolutely got near term equity price uncertainty.

Cost inflation continues to be a factor, uncertainty around interest rates going higher, geopolitical risk emerging in Europe and likely to get worse before it gets better.

Secondly, the cost of equity of small caps remains very high after their underperformance versus large caps over the last two years.

It's very expensive for small companies to access growth capital through issuing new shares.

But there are many wounded athletes, many great companies where their valuations have come down quite a bit, but they're still growing extremely well.

I think across our portfolio, we've got a number of companies growing sort of 30 to 50% year on year, and their valuations might be down 80%.

over the last two years and these companies all have solid foundations for future value creation and an ability to pay coupons so in our view today the market is ripe for convertible bonds.

But how convertible bonds performed longer term versus other asset classes?

Well in this chart in the light green line we have global convertible bonds versus most other asset classes so global corporate bonds, global equities,

the ASX large cap indices and the ASX small orders.

And you can see that over a 20 year period, convertible bonds have outperformed these other asset classes.

Here we look at the 20 year annualised performance in the left chart of convertible bonds versus the asset classes and in the right hand chart, the 20 year annualised volatility.

And we can see that convertible bonds have delivered similar returns to global equities whilst outperforming

the indices in Australia and global corporate bonds.

But in the right hand chart, we can see they've done it with much less volatility than equities.

So this goes to the point that we were making earlier on.

The convertible bonds are a better risk adjusted way to get equity like returns, but you're doing it with lower volatility.

And the key reason for this is that when you have a capital drawdown on equity, you don't have the same capital drawdown with a convertible bond.

So when markets begin to recover, you're starting from a higher base, which means you have less losses to recover.

And that enables you to outperform equity with lower volatility through a convertible bond instrument.

How convertibles behave during different market cycles.

Well, we've got a number of different market events here, starting with the great 90s bull market.

where you can see equities rallied 21% and the convertible bond industry participated in 90% of that upside, returning 19%.

I won't step through each of these, but if you cast your eye all the way across to the second last one from the right, the COVID-19 drawdown, you can see that in 2020 global equities fell 19.6%, whereas convertible bonds only fell 13.6%.

This is the point I was making about starting off a higher base when a recovery comes through.

Convertible bonds in this scenario only captured 69% of the downside of equity.

And so that's a key factor in the outperformance of the instrument when markets recover.

So in summary, convertible bonds protect against drawdowns.

They enable you to participate in most of the equity upside.

They deliver consistent income and therefore provide superior

risk adjusted returns versus equity.

So just touching very quickly on pure asset management in the context of convertible bonds.

So pure asset management is Australia's leading convertible bond fund.

We've been running for five years now.

We have two funds, the pure income and growth fund, which is industrials focused and the pure resources fund, which is the name would suggest is resources focused.

So just briefly on this chart, you can see volatility on the Y axis.

annualised returns on the x-axis.

You can see that both of the pure convertible bond funds have substantially formed their comparative indices with significantly lower volatility.

Now, when we think about the earlier slides of convertible bonds outperforming in key market drawdown periods, we can ask the same question of the pure income and growth fund, which has been around for five years.

So we traded through the severe market event of COVID in 2020.

and the severe market pullback through reflation event in 2022.

The light green bar is the is the industry, which in both cases declined between 30 to 40 percent.

And you can see that in both instances, the convertible bond fund significantly outperformed what an underlying equity exposure delivered.

Similarly, the Resources Fund, which has been around for two and a half years,

traded through the significant market pullback in 2020 and significantly outperformed equities as a convertible bond strategy again.

So showing those characteristics that we see for the global convertible bond indices.

So I hope that's given you a good flavor of why convertible bonds are a better risk adjusted way to invest in equities and a brief look into how that strategy has traded in Australia through pure asset management as well.

Thank you for your time.

And if you'd like to get in touch, please do.

Thank you, Nick.

Given the apparent relative success of convertible bond strategies elsewhere in the world, why do you think we haven't seen more of these strategies in Australia?

It's a good question.

Historically, Australia has certainly had less sophisticated capital markets than the rest of the world.

I guess like a lot of things, it sometimes takes us a bit of time to catch up.

We've had very strong equity markets for a couple of decades overall, with large caps delivering healthy dividend yields, and that's really attracted a lot of the capital.

We are starting to get more sophisticated now, so you've seen an explosion, for example, of private credit funds over the last five years, particularly as banks have pulled back from funding certain sectors of the market.

And I think we will see more convertible bond funds

come to the market as investors start to understand the risk adjusted benefit of these strategies.

Certainly when we look to the US and Europe, there are a number of convertible bond fund strategies and typically they perform well versus equities and corporate bonds.

And so I think this is something that you will continue to see just as Australia naturally progresses through its maturation of its capital options relative to the rest of the world.

Thanks Nick.

My next question is what is better investing in a private credit strategy or a convertible bond strategy?

That's a good question.

I think there's room for both strategies in a portfolio.

You get different unit price performance characteristics between the two.

So in a private credit strategy, you're going to get much more consistent monthly returns, positive returns in the unit price.

Because convertible bonds can, in certain instances, particularly once converted, have equity like characteristics, you can have periods of negative unit price performance if there is a pullback in some of the underlying equity value.

So in other words, the volatility of a corporate bond strategy will be less than that of a convertible bond strategy.

But I think for this part of the cycle that we're moving into, high cost inflation, high interest rate,

You know we are moving into the high default and of the cycle and so you know if we look at 20 year default rates in the US.

Across high yield credit at this point in the cycle, it does jump up to kind of 6% plus in terms of default rate, so I think it's important to have an element of alpha in the portfolio because there will be credit losses and if your only way to recover that the value of that credit lost is through,

establishment fees on writing a new corporate bond, it's going to take you a very long time to get back, you know, say if you've had a 5% capital loss on the portfolio, it's going to take you a very long time to get that capital back.

Whereas if you have some alpha, some equity exposure through a convertible bond, you know, you can have a single position go up 10, 20, 30, 40, 50% if you get the call right.

And that alpha can be very important in terms of helping you recover.

say if you have a capital loss on a credit piece.

So I'd summarise by saying I think there's a place for both, but at this end of the cycle, whether you're considering private credit funds or corporate bond funds, you would probably do well to check that there is some alpha as part of that portfolio, one way or another.

Thank you very much, Nick.

It's great to see you.

Take care.