Convertible bond prices still imply cautious expectations

Convertible bond prices still imply cautious expectations

The equity market has evolved from a contrarian trend to a difficult chase, leaving investors feeling exhausted. In August, we believed that the current state of the market was contradictory: valuations were already low enough, but technical trends were weak. An important observation point may be the breakthrough of short-term moving averages. In fact, the breakthrough did occur this time, but the market moved too fast after the breakthrough, making it difficult to follow. However, this is actually a normal or "confirmation" process: when a real breakthrough reversal trend occurs, it is likely to move quickly in the direction of the breakthrough right after the breakthrough is completed. Investors find it difficult to truly "wait for a pullback before getting involved." The good news is that this indeed constitutes a technical breakthrough reversal. Therefore, we believe that investors do not need to hesitate about the existence of the trend, but the real issue at hand is the "entry point." From a technical perspective, as shown in the following chart of the CSI 1000 Index, after the breakthrough, major moving averages (such as the 20-day and 60-day) have turned upwards. However, the deviation rate is high, and we believe that there is a greater possibility of wide fluctuations in the next two weeks to wait for the moving averages to converge.

Chart 1: CSI 1000 Index Candlestick Chart

Source: Wind, CICC Research Department;

Surprisingly, convertible bonds have shown a calm valuation. It is easy to see that the valuation has not continued to rise recently, as we expected in the previous weekly report. Simply put, the bond market adjustment and the profit effect may take longer to accumulate the effect of "additional funds" - perhaps before such statements arrive, it will be the true golden period for convertible bonds.

Chart 2: Premium Rate per Hundred Yuan (unit: %)

Source: Wind, CICC Research Department;

In practice, investors find it more challenging to communicate than to calculate. For example, even if clients can understand the algorithm of implied volatility, there are few clients who directly trade volatility. It is even more difficult to understand the "expectation of implied future volatility." Here, it may be worth trying a different approach: using the same option pricing formula, instead of treating volatility as a variable, fix the volatility at a static historical value, and calculate the actual implied stock price expectations of the current convertible bond price based on the stock price as a variable For example, calculating 10% can be understood as the expectation that the convertible bond price already includes a 10% increase in the underlying stock, which is a certain degree of overdraft. Conversely, -10% implies an expected 10% decline, which is a safety cushion reserved in advance.

Chart 3: Implied yield of the underlying stock corresponding to the valuation of convertible bonds

Source: Wind, CICC Research Department

Although the calculation process may be very close, for end customers, the intuitiveness of understanding is much better. In addition, a hidden benefit is that we can calculate the values normally, whether it is for the "double high bonds" with a premium rate of hundreds or the near-redemption varieties with negative premium rates.

As shown in the chart above, on average, current convertible bonds still reserve a safety cushion of around 20% for the underlying stock to decline. Although slightly higher than in August, it is still at a historically low level. In the past, when approaching this level in late 2018, around July 2019, and early 2021, investors received good returns. Here, it is once again emphasized that the opportunity with convertible bonds is not to make money from valuation, but to make asymmetric gains when the valuation is reasonable or even low. When money is made from valuation or continues to make money from valuation, the market will start discussing the allocation value of convertible bonds, attracting incremental funds, and discussing the logic of higher valuations, all of which are signs of the end of the market trend.

Of course, some convertible bonds are not just "calm". We previously pointed out the issue of high-quality convertible bonds with high premiums, which has become a real issue this week. Because the higher the premium rate, the further away from par, and the less impact on these companies before and after the market turns around. As long as they do not quickly transform into balanced or equity-like securities, these bonds are also among the first to extinguish historically.

We still recommend going against the tide recently. A simple combination of "double low" + momentum (or volatility) can help investors find varieties that are currently more valuable in the game, as seen in the top ten this month. Similarly, going against the tide, there are two other types of varieties. One is varieties that may be close to 130 yuan in price but have a very low premium rate, which historically may quickly become targets for redemption. The other is that as the market warms up, it will reduce the difficulty of the downward adjustment game. If considering low-priced bonds, it is better to focus more on varieties that are close to the recent reset date for downward adjustments and have a relatively higher probability of downward adjustments.

Risks

Macro policies exceed expectations, individual bond fundamentals fluctuate beyond expectations, and pure bond assets adjust beyond expectations.

Authors: Yang Bing from CICC, Luo Fan, etc. Source: CICC Fixed Income Research Original Title: "[CICC Fixed Income Convertible Bonds] Convertible bond prices still imply cautious expectations".

Analyst Yang Bing, SAC Practicing Certificate Number: S0080515120002

Analyst Luo Fan, SAC Practicing Certificate Number: S0080522070003