Ratchet clause: a unique and valuable asset

11 April 2019

Cédric Daras

RAM (Lux) Tactical Funds - Convertibles Europe

A slowing global economic environment and increasing downward pressure on businesses from the U.S.-China trade war, have led central banks to consider a monetary policy U-turn.

Following a prolonged period of tightening cycle, the Fed is marking at least a pause for 2019. The ECB continues to highlight risks to the downside, pushing out the timing of when it expects to raise interest rates. The consequences were a flattening of the U.S. Curve while the German 10-year yields ended the month in negative territory (the first time since October 2016).

Amid this context, European equity markets finished up (+1.39% for the Euro STOXX Net Return). However, this increase was driven by non-cyclical sectors such as Personal & Household Good (+7.12 %), Food& Beverage (+6.43%), Real Estate (+5.6%), while Banks (-4.98%) and Basic Resources (-3.91%) which suffered the most. Credit spreads remained stable: Itraxx main (+4 bps to 65 bps) / XOver (-3 bps to 272.5). German, French and Italian yields declined (-25bps for the 10-year) while the Spanish yield underperformed (-8 bps for the 10 year).

Convertible bonds have benefited both from both equity market performance and duration impact. Our Fund suffered from its underweight in Real Estate and in Communication Services: Cellnex, and especially Inmarsat, which has been the target of a bid from a consortium. Despite a weak equity sensitivity, the CB’s finally captured 120% of the equity performance thanks to the activation of the ratchet clause. We exposed the CBs due to this interesting clause but at a lower weight than the index because of the continuous negative pricing pressure in this business and a leveraged balance sheet. The shorter duration vs the benchmark was also a negative relative contributor.

The primary market was calm with one new issue: 500m€ of Air France 0.125% 2026. We participated owing to the attractive characteristics of this new issue.

On the technical side, implied volatilities continued their declined to reach 28%, a level considered to be historically attractive while the spread of implied volatility between convertible and listed options have tightened by 197 points to reach 513 points.

Implied Volatility

We think that current characteristics moderate equity sensitivity, cheaper implied volatility and ratchet clause make the European Convertibles market particularly attractive, offering a great opportunity for investors to be exposed to the equity market albeit at lower risk.

*Sources : RAM Active Investments