The realm of convertible bonds has long held the reputation for offering both safety and reward to investors, encapsulated by the saying "a bottom line below and returns above." This concept gave rise to a compelling investment logic often described as "poor companies, good convertible bonds." However, as we look towards the present and the future, this once-dependable investment principle appears to be fracturingThe investment in convertible bonds must now revert to a foundation rooted in financial analysis and market research, leaving behind tactics that once relied on arbitrary speculation.

Since the expansion of the convertible bond market in September 2017, the market experienced a vigorous five-year boom period, particularly between 2019 and 2023. The total size of the market surged from hundreds of billions to nearly a trillion yuan, with daily trading volumes skyrocketing from only a few hundred million to over a thousand billion yuan

Notably, beginning in early 2018, convertible bond indices not only exhibited remarkable annualized returns but also showcased lower volatility and improved risk-return ratios, consistently outpacing other major indicesThis impressive data clearly underscored the attractive "dual nature" characteristic of convertible bonds, blending both offense and defense in investment strategies.

Yet, with the recent dramatic fluctuations in the convertible bond market, one must ponder if these volatility swings disrupt the traditional investment logic that has governed these instruments for so longAs prices plummet, the pressing question arises: where does the potential for investment opportunity now lie? This is a question each investor needs to contemplate and analyze thoroughly.

Reflecting on Past Market Corrections

When discussing convertible bonds, the pivotal moment is often traced back to September 2017. This marked the point at which convertible bonds found solid footing as a distinct branch of A-share equity products, which subsequently led to several standout individual securities

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That said, no market or product can experience unblemished growth without encountering inevitable correctionsDespite being the best performer among equity indices, convertible bonds have faced notable downturns four times over the past six years, including the significant downturns of the entirety of 2018, the early 2021 crash, the rapid plunge of 2022, and the recent dramatic drop in 2023. Other equity products often reveal their investment opportunities through price declines, with convertible bonds being no exceptionThe essence lies in conducting thorough reviews and strategic planning, enabling one to mitigate risks while capitalizing on potential opportunities in the future.

After the expansion phase, the first systematic decline in convertible bonds dominated the entirety of 2018. The reasoning behind this decline was quite straightforward: it was intrinsically linked to the broader downturn in the equity market

Major indices, excluding the Shanghai 50, witnessed declines of nearly 25%, and smaller-cap indices suffered even larger drops exceeding 30%. During this year, valuation and pricing frameworks for convertible bonds became compressed to a degree that could be likened to a fully compressed springRecognizing this threshold valuation remains vital.

Rewinding to that period, one can pinpoint October 18, 2018, as the day when convertible bonds hit their lowest pointOn that particular day, a total of 92 Shanghai and Shenzhen convertible bonds collectively recorded a trading volume of 690 million yuanThe average closing price was 94.74 yuan, and the median closing price came in at 93.13 yuan, backed by an average yield of 3.58% and a median premium of 34.9%. This extreme valuation was a benchmark not reached for several years to follow.

The extremely lower trading volume also signified a substantial price floor, as no other investor was willing to sell at such low points.

Looking at the median price of 93 yuan and the average price of 94 yuan, one can discern the absolute bottom point

At that moment, there had never been a black swan event causing defaults in convertible bondsThe first significant defaults occurred six years later, reaffirming that faith in convertible bonds maintained its vigor.

Further, the average yield of 3.58% coupled with a median premium of 35% demonstrated a strong value propositionThis highlighted the near-free value of their options.

Investors could rely on this pool of 92 securities to identify those that displayed both defensive and offensive characteristics, financial yields, low premiums on conversion, high option value, variability, and a significant amount of "free" options.

To summarize the factors leading to the bottom of convertible bonds in October 2018: the drop in the stock market drastically eroded the confidence of convertible bondholders; a severe liquidity crunch paired with insufficient coverage from prominent institutions; these elements contributed to a rare low in pricing and an extended opportunity for accumulation

As the stock indices rebounded in 2019 and institutional investor interest in convertible bonds escalated, especially with the rise of fixed income + strategies, the convertible bond market flourished once more.

The second significant decline in convertible bonds occurred in early 2021 and was particularly influenced by the credit market's turbulenceThe end of 2020 was marked by the defaults of AAA-rated state-owned enterprises such as Yongmei Group and Brilliance Auto, which sent shockwaves through the convertible bond market and triggered a steep dropWhile the default of these external bonds was a catalyst, the intensifying decline was equally driven by the inherent market emotions, prevailing sentiment, and extreme divergence.

Post-October 2020, the convertible bond market erupted into a frenzy, leading to multiple amendments in trading regulations imposed by market regulators

Brilliance's AAA-rated bonds had already encountered a default situation, as news of Yongmei’s impending default loomed closelyThe equity market was characterized by extreme divergence and congestion, under which the valuations of convertible bonds underwent rapid compression.

The low point of the 2021 adjustment represented one of the greatest investment opportunities the market had exhibited for yearsAt that time, the number of convertible bond options soared to 341, extending across varying industrial sectorsDespite the price indicators being higher than those of 2018, the option attributes (offensive properties) were remarkably superiorThe prices of many convertible bonds hovered near face value, yet numerous instruments sported conversion values hovering around a strong 90 yuan, well-distributed among various industries with diminished credit risk.

Hence, the rapid adjustments in the convertible bond market induced by external credit risks presented investors with exquisite configuration opportunities in early 2021, further popularizing "dual-low" strategies and the favorable practice of "spreading the risk." However, as history teaches, strategies widely adopted by the investment community invariably face obsolescence.

In April 2022, the convertible bond market encountered yet another swift correction, this time directly tied to movements within the equity market

The characteristics of this latest decline were notably higher than both the 2018 and 2021 troughs; the market lacked the momentum to decline furtherThis was due to the increasing capacity and inertia of the market, compounded by heightened institutional participation.

Ultimately, across these previous three downturns, the prevailing trends and sentiment of the equity market played a decisive role in driving these correctionsWhile credit risk served as a vague auxiliary factor—acting primarily as a trigger only during the second downturn—the fundamental cause remained the extreme fragmentation of the equity market, along with liquidity issues and transaction density.

Participants who engaged during these market downturns had varying degrees of returns afterward

Crucially, successful participation hinged on one primary condition: the convertible bond market must encounter broad declines, mandating a comprehensive collapse that leads to significantly compressed valuationsThis principle holds true across all phases of market downturnsThe all-encompassing slump of 2018 illustrated this well; individual securities dipped comprehensively, with the median and average convertible bond prices plummeting to 94 yuan, marking the highest prospect for convertible bond opportunities within these yearsThe extreme differentiation experienced in early 2021 only propelled the market toward a swift, extensive downturn, which efficiently established new lows by early FebruarySimilarly, the April 2022 trend revealed a straightforward scenario where underlying stocks experienced widespread collapse, inducing a collective slide in convertible bondsThis was swiftly followed by a recovery in confidence and an all-encompassing rebound.

Current Downturn: The Apparent Volatile Factors

In contrast to earlier downturns, the present decline has unveiled certain previously overlooked risk factors, shattering entrenched logic associated with convertible bond investment

Leading up to this, the convertible bond market had witnessed numerous iterations of preemptive events that should have primed astute investors for potential pitfallsThese newly surfaced risk factors must remain in the spotlight for future forays into convertible bond investments.

Flagging this volatility in the convertible bond market, two critical events materialized: on July 31, 2023, China witnessed its first delisting of a convertible bond—Blue Shield Convertible Bond—due to the issuer, *ST Blue Shield, suffering a series of dismal annual performances and subsequently receiving an audit report with an inability to form an opinionFollowing this, on May 17, 2024, SouYute announced insolvency due to liquidity shortages, rendering Souyute Convertible Bond the first to experience real default.

Prior to these events, investors felt secure as convertible bonds had never been associated with delistings or defaults

Over the course of 20 years in the market, convertible bonds earned their nickname as “having a bottom line and a profit ceiling.” This concept fostered an investment strategy dubbed “poor companies, good convertible bonds,” predicated on the notion that these companies could more easily adjust conversion prices and demonstrate stronger conversion incentives (debt restructuring). While poor stock performance had accompanied these bonds, the dramatic fluctuations during their lifespan would effectively allow them to transition smoothly into conversion.

In light of current events, the previous logic surrounding convertible bonds no longer stands, necessitating a return to analyses centered on financial fundamentals and the inherent dynamics of market fluctuationsThus, it becomes imperative to revisit and examine the evident risk factors now surfacing in the convertible bond landscape.

At the forefront is the risk of delisting, encompassing both trading-related and financial-related delistings

Among these financial delisting triggers, the focus shifts to companies continuously reporting losses and those with abysmally low core revenue streams or audit reports with qualified opinions or inability to express opinionsTrading-related delisting, conversely, poses heightened danger due to its straightforward nature; the imminent risk of principal stocks dipping below 1 yuan could easily ignite an avalanche of sellingTherefore, convertible bonds connected to underlying stocks priced under 2.5 yuan or with overly low price-to-book ratios should be approached with caution.

Following that, we must consider exit risksGuided by the trend toward tightening intermediary accountability, deviations in convertible bond ratings are expected to proliferateGiven that public funds hold a dominant share of convertible bonds, downgrades of corporate ratings can provoke swift selling panics

Hence, convertible bonds linked to companies with excessive liabilities, cyclically adverse industries, endured losses, and poor core operations should be avoided, particularly those with high institutional ownershipGenerally, a drop from AA+ to AA can place entities at risk of losing access to bank financing and many insurers; further declines from AA to AA- will trigger cascades of withdrawals from most pension funds; similarly, from AA- to A+, both the public fund landscape will follow suit.

Thirdly, broad market risks linger, including factors such as the pledging rates of convertible bond stocks and the dilution effect of convertible bond sizes on the circulating market capitalizationIn such scenarios, even the highly sought-after clause of "special amendments" could falter in efficacyExcessive convertible bond volumes can apply clear pressure on stock prices, while amendments may stretch dilution further, introducing additional strains on the underlying shares

Furthermore, considerable sizes of convertible bonds raise doubts about the underlying stocks' actual capacity to absorb this hefty debt load.

Lastly, we must explore financial risks associated with revenue size, net profit margins, gross profit ratios, inventory turnover ratios, and the ratios of receivables and prepayments to net assets, among other crucial indicators exhibiting signs of health.

Consequently, the discipline surrounding convertible bonds must revert to one grounded in fundamentals, industry selections, macroeconomic evaluations, and funding state considerationsThe previous strategy of “poor companies, good convertible bonds” may not witness resurgence for an extended periodIn fact, since the beginning of 2023, the convertible bond market has divided markedly, with the dual-low strategy rapidly becoming invalidated.

Volatility as a Source of Profit

Within each cycle of significant market corrections lies fertile ground for opportunity

This current context is no different, and it becomes crucial to comprehend the differential markers across significant points in the convertible bond market to cultivate a supportive investment platform.

With a sufficiently diverse sample of convertible bonds currently in play, median price indicators appear objectively favorableIt seems challenging for median prices to collapse to the extreme levels witnessed in 2021 and 2018 due to ample institutional and retail market coverage, ensuring robust liquidity—and indeed, interest rates presently remain lower than in previous yearsPresently, average prices have dipped below those of 2021, substantially due to the overabundance of severely discounted convertible bonds dragging down averages, although the median price remains relatively insulatedCorrespondingly, the average yield has surged, indicating the 2022 downturn may have reached its nadir as the average maturity term for these bonds has considerably shortened; the average yield threshold deserves to be assessed at deeper levels

An unfortunate aspect of the current landscape is that convertible bond premiums are notably high, while parity levels are distinctly low, attributed to significant declines among smaller stocks.

Upon verifying systemic market opportunities and valuations, two primary strategic lines of attack should be deployed when selecting convertible bondsThe first line hinges on financial and market indicators to rule out undesirable characteristics: stocks priced below 2.5 yuan, pledge rates topping 30%, price-to-book ratios less than 0.7, consecutive quarterly losses, convertible bonds outstripping 35% of circulating stock capital, annual core revenues below 800 million yuan with quarterly revenues dipping below 200 million, liabilities exceeding 50%, total market values under 1.5 billion yuan, and negative yield to maturity, among others