Convertibles: Sharp Handling of the Trump, Dow 20,000 Turns
We recently caught up with Portfolio Manager, Edward Silverstein, of the MacKay Shields’ Convertible Bond Team, who advises a 2016 Lipper Fund Award winner, MainStay Convertible Fund.1
Election to December 31
Following the November 8 election and a few hours of market upheaval, the stock market soared higher, with the Dow Jones Industrial Average finishing the year just shy of 20,000 – a level it would later reach on January 25, 2017.
If we look at asset class level performance between the election and year-end 2016, the BofA Merrill Lynch U.S. Convertibles Bond Index returned 3.99%, or about four-fifths of the 4.98% return of the S&P 500 Index. By contrast, a popular bond benchmark, the Bloomberg Barclays U.S. Aggregate Bond Index, returned -2.10%, as investors focused on the possibility of tax cuts, fiscal stimulus, and reduced regulations.
Convertibles Captured 80% of the S&P 500’s Rally after the Election
Source: Asset class level performance between 11/8/16 and 12/31/16. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.
The latest run-up serves as a reminder that convertibles can behave quite differently at times from other bonds. Over the past 15 years ended December 31, convertibles had a negative .29 correlation to long-term Treasurys and a negative .26 correlation to intermediate-term Treasurys.2
Pledges, Promises, and 60/40
Looking ahead, Silverstein believes the new administration has to transform pledges, promises, and executive orders into some more tangible accomplishments in the next 9-12 months to keep the market’s animal spirits, well, up. Meanwhile, corporate profits are growing, and the typical convertible bond today (the average bond that makes up the index) has a price of about 116 and a “delta” near .60, meaning convertibles might realistically be expected to capture about 60% of any orderly upward stock market move or, alternatively, 40% of any orderly downward stock market move.3
Relative Value and Economic Outlook
Silverstein and the team believe equities and equity-linked securities are attractively valued, compared to the low yields on offer on U.S. Treasury bonds and investment-grade debt. They feel the U.S. stock market is fully valued, but should benefit, as profits grow.
Modest economic growth is expected to continue in the U.S. and globally, alongside low, but rising, inflation and interest rates. The Fed is expected to gradually raise rates, but monetary policies around the world should remain accommodative. Given these conditions, we believe equities and equity-linked securities have the potential to perform reasonably well in the 12-18 months ahead. However, it is not an environment that encourages taking unnecessary risks. In this sense, convertible securities can help investors participate in equity market advances, while providing the potential for some downside protection, should volatility occur.
Silverstein is generally encouraged by the fourth-quarter 2016 earnings calls he has listened to so far this reporting season. The team is overweight energy and industrials versus its benchmark and peers. By contrast, the team is underweight financials, utilities, and real estate investment trusts (REITs).
Odds ‘n’ Ends
Convertible issuance has been robust in 2017, so far. Issuance in January totaled $3.3 billion.4 Companies want to obtain low-cost financing, given that interest rates may be higher down the road than they are today.
Continued economic growth, low but rising inflation, and attractive valuations provide an encouraging backdrop to an asset class that has little correlation to changing interest rates and less historical volatility than the equity market.
Before considering an investment in the Fund, you should understand that you could lose money. Issuers of convertible securities may not be as financially strong as those issuing securities with higher credit ratings and may be more vulnerable to changes in the economy. Investing in below investment grade securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds. Foreign securities are subject to interest rate, currency exchange rate, economic, and political risks. These risks may be greater for emerging markets. Funds that invest in bonds are subject to interest-rate risk and can lose principal value when interest rates rise. Bonds are also subject to credit risk, in which the bond issuer may fail to pay interest and principal in a timely manner.
1. According to Lipper, the awards recognize funds for their consistently strong risk-adjusted performance relative to their peers, based on Lipper’s proprietary performance-based methodology. Those funds with the most consistent return within their classification were declared the winner over three, five, or 10 years. MainStay Convertible Fund Class I shares received the Lipper Fund Award in the Convertible Securities Funds category for the three-year period annualized out of 71 eligible funds as of 11/30/15. For a detailed explanation, please review the Lipper Fund Awards Methodology document at lipperweb.com.
From Thomson Reuters Lipper Awards, ©2016 Thomson Reuters. All rights reserved. Used by permission and protected by the Copyright Laws of the United States. The printing, copying, redistribution, or retransmission of this content without express written permission is prohibited. Award for U.S. region only.
2. Bloomberg 2/8/17 last data point 12/30/2016. Based on rolling monthly returns of the BofA Merrill Lynch U.S. Convertibles Index with the Bloomberg Barclays U.S. Intermediate Term Treasury and Long-term Treasury indices.
3. Bank of America Merrill Lynch and Bloomberg, as-of 2/7/2016.
4. Bank of America/Merrill Lynch, as-of January 2017.
Opinions expressed are current opinions as of the date appearing in this material only. The information and opinions contained herein are for general information use only. MainStay Investments does not guarantee their accuracy or completeness, nor does MainStay Investments assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are subject to change without notice, and are not intended as an offer or solicitation with respect to the purchase or sales of any security or as personalized investment advice. There can be no guarantee that any projection, forecast, or opinion in these materials will be realized. Past performance is no guarantee of future results.
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The Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based flagship benchmark that measures the investment-grade, U.S. dollar denominated, fixed-rate taxable bond market. The index includes Treasurys, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM pass-throughs), ABS, and CMBS (agency and non-agency).
BofA Merrill Lynch U.S. Convertibles Bond Index – The Index consists of convertible bonds traded in the U.S. dollar-denominated investment-grade and non-investment-grade convertible securities sold into the U.S. market and publicly traded in the United States. The Index constituents are market-value-weighted based on the convertible securities prices and outstanding shares, and the underlying Index is rebalanced daily.
Correlation is a statistic that measures the degree to which two securities move in relation to each other. Correlation coefficient indicates the strength and direction of the relationship between the movement of two investments. If two securities are perfectly correlated—that is, they have a correlation of 1.00—their prices move in lockstep with one another. Diversifying a portion of the portfolio with securities that are not highly correlated may help reduce volatility in the portfolio. Generally, a correlation of 0.70 or less would indicate that the two investments are not highly correlated. If the correlation coefficient is negative, the two investments will move in opposite directions from one another. A correlation coefficient of -1.00 would indicate that two investments move in exactly the opposite direction from one another.
Delta – measures the change in the convertible bonds price with respect to the change in the underlying common stock price.
S&P 500 Index – The index measures the performance of the large-capitalization sector of the U.S. equity market and is considered one of the best representations of the domestic economy. Utilizing a market-cap weighting structure, this index invests in the 500 largest U.S. firms, including names like Apple (AAPL), Exxon Mobil (XOM), and General Electric (GE). All companies must have a 50% public float to be considered for inclusion in the benchmark.
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