Morgan Stanley Fund: When will the convertible bond market reach a turning point?

Morgan Stanley funds published an article stating that convertible bonds have long been considered a derivative financial instrument with no cap on the upside and a safety net on the downside. They show strong offensive characteristics during an uptrend in the stock market and defensive characteristics during a downtrend. The dual nature of convertible bonds makes their long-term investment return significantly higher than major stock indexes. Even in a bear market for stocks, the overall decline of low-priced convertible bonds supported by bond floors is relatively manageable. However, the investment return of the convertible bond market in 2024 is very disappointing, showing no resilience to declines. As of September 13, the China Convertible Bond Index fell by 6.69%, the equally-weighted Convertible Bond Index fell by 11.33%, and the market share of convertible bonds with a face value below 100 yuan exceeded a quarter. Superficially, the weak performance of the convertible bond market in 2024 can be attributed to the overall weakness of the stock market and the small and medium cap styles. However, the deeper reason lies in the persistent concerns about convertible bond credit risks, and the liquidity shock caused by institutional concentrated selling exacerbates the adjustment of the convertible bond market. The process of reassessing convertible bond credit risks in this round has gradually overturned the traditional pricing model of convertible bonds, leading to continued adjustments in low-priced convertible bonds breaking historical norms. High YTM convertible bond strategies and dual low convertible bond strategies were once very successful types of strategies. However, 2024 has become a turning point for these two strategies. Strategies based solely on high YTM or dual low principles have performed very poorly, mainly because convertible bonds with poor credit ratings and delisting risks have relatively low valuations, making them more susceptible to inclusion in portfolios based on high YTM or dual low principles, thus significantly dragging the performance of the portfolio. After experiencing the reassessment of credit risks, will the convertible bond market see a recovery rally in the future? Currently, it seems unlikely that the convertible bond market will replicate the rapid recovery rally seen in 2021. The impact of the credit risk shock on convertible bond market in early 2021 was comparable to the current adjustment, but the rapid recovery of convertible bond market pricing in 2021 mainly relied on the strong bull market for small and medium cap stocks that year. In the absence of systemic opportunities in the stock market, the valuation recovery process for low-priced convertible bonds in the future may resemble that of private enterprise ordinary credit bonds after the default wave in 2018, with the credit spread expected to remain high and bond price recovery mainly dependent on improvements in the cash flow visibility of the issuer and the reduction in remaining term. Overall, the long-term value of convertible bond assets is gradually becoming apparent, with some convertible bonds with decent fundamentals being wrongly penalized during the market adjustment. Additionally, some convertible bond issuers are actively reducing their conversion prices, which may see these bonds experiencing a value rebound first. However, the long-term investment opportunities in the convertible bond market still depend on the overall improvement of the stock market. In terms of convertible bond strategies, the basic analytical framework of high YTM and dual low strategies still has corrective potential, and in the future, there is a need to strengthen research on the fundamentals of the underlying stocks of convertible bonds, avoid convertible bonds with credit flaws and potential delisting risks, and seize structural investment opportunities in the convertible bond market.