Convertible Bonds: Built for Times Like These
Investors may be asking themselves how much steam is left in the stock market rally, while at the same time, have concerns about the effect of rising rates on bonds. Convertible bonds eliminate the need to choose the lesser of investor concerns when allocating assets. They’re not new or exotic: Convertible bonds have been around since the 1800s, when railroad companies began issuing them to raise much-needed capital. The basic premise behind a convertible bond is to combine a bond with a call option, providing an investor the chance to participate in potential equity appreciation, while mitigating downside participation with bond-like characteristics, specifically, a periodic coupon and principal repayment at maturity.
There are numerous reasons an issuer chooses to issue a convertible security. If a company is young or otherwise has limited access to public equity markets or the stock price is depressed, its owners may not want to issue equity at a low price and dilute the current shareholders. By issuing a convertible bond, the company is allowing itself access to capital, while effectively issuing equity at a higher price, if and when the stock price appreciates and the bond is converted.
Also, as an alternative to a straight bond, the issuer is able to pay a lower coupon than a bond since the conversion option is valuable to the investor. Being that a company issues a convertible bond to issue equity at a future date when the market price is higher, it makes sense that an investor would lose money if they were able to convert at issuance.
Figure 1 illustrates the hybrid nature of a convertible security. Note the distance between the convertible price curve and the parity line – this is known as the conversion premium (the difference between the value of the convertible bond and the value of the equity, if converted). As the stock price (x-axis) increases, the convertible value moves more in tandem with the stock price, making it behave like an equity. If the stock price declines and moves more into the “yield instrument” segment, you will note that the convertible value decreases at a much slower rate than the stock. The security converges along the “investment value” line, which is the par value of the bond. The bond-like characteristics provide the potential for downside protection. Of course, bonds carry credit risk, so continuing further to the left into the distressed segment, the value of the investment is no longer backstopped by the par value. However, as yet, there have been no convertible defaults YTD, and the distressed segment is at a post-crisis low (1.8% of face value)1.
Figure 1: Hybrid Behavior of a Convertible Bond
Source: BofA Merrill Lynch Global Research, March 9, 2017.
How have convertibles fared in rising rate environments?
The convertible universe is a blend of investment-grade and non-investment-grade issuers. It features high correlation to small- and mid-cap equities, low correlation to investment-grade credit, and a negative correlation to US Treasury bonds. Therefore, an investor can reasonably expect convertibles to behave inversely to Treasury bonds when rates rise. Keep in mind that interest rates tend to rise when the economy is expanding. In a growing economy, many companies may generate profit increases and improved financial performance, and as such, experience stock price appreciation. In Figure 2, we view the performance of convertibles, high-yield bonds, US core bonds, and US equities during four rising rate periods. The performance is overlaid with the magnitude of the yield increase of the 10-year Treasury bond during each period (right-hand axis). The chart supports the case for investing in convertibles during a rising rate environment, as the results are rather compelling versus both stocks and bonds.
Figure 2: Cumulative Performance during Rising Rate Periods
Sources: Morningstar Direct, 4/30/17, and Treasury.gov. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.
In addition to having low correlations with investment-grade bonds and US Treasurys, convertibles provide diversification with respect to equities and even high-yield bond issuers. Specifically, 82% of non-investment-grade convertible issuers are not represented in the high-yield universe, providing broader investment opportunities.2
On a sector basis, the convertible market is heavily weighted towards technology, financials, and healthcare. Technology and health care issuers tend to access the convertible market because in many cases, they are startups or newer companies without track records and convertibles are their best option for raising capital. Financials were issued in greater volumes pre-crisis and are generally now yield instruments that are unlikely to be converted. From a market-capitalization perspective, approximately 60% of the market is comprised of large-cap companies, while 30% and 10% are mid caps and small caps, respectively. From both a correlation and style point of view, the convertible asset class provides opportunities for diversification and an expanded investment universe. In fact, the efficient-frontier analysis (Figure 3) shown below, constructed with 20 years of historical performance, demonstrates that adding convertibles to a bond portfolio offered greater risk-adjusted returns than adding equities to the bond portfolio. In other words, for a given level of risk (standard deviation) over the time period, convertibles generated greater returns than equities.
Figure 3: Efficient-Frontier Analysis
Source: Morningstar Direct, May 1997 – April 2017. Equities are represented by the S&P 500 Index; bonds are represented by the Bloomberg Barclays US Aggregate Bond Index and convertibles are represented by the Bank of America Merrill Lynch US Convertible Index. Chart created by New York Life Investment Management. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.
Tempered Way of Playing Equities
While convertible bonds offer potential equity participation, an investor should not expect all of the equity upside. The trade-off to getting the bond-like downside participation via bond characteristics involves leaving some upside potential on the table. It can be called a chicken’s way of playing equities because an investor can participate, albeit not fully, in equity market rallies, but retain some level of potential protection should the markets stumble.
Given the current market environment, with the DJIA surpassing the 20,000 mark and expectations of continued Fed-interest rate increases, adding an allocation to convertibles may be an attractive place for investors with cash on the sidelines to invest. For an investor who is not sure how high the stock market can go, they can buy potential protection at a cost of only some of the upside. If the same investor is skittish about rising rates and how that might impact a fixed-income portfolio, we have demonstrated how convertibles have performed in rising rate environments. So, to answer the question of stocks or bonds: Convertibles.
- Source: Barclays 4/27/17. “Default risk eases after spike in 2016”
- Source: Barclays 3/13/2017. “Convertible Bonds for High Yield Investors”
Index performance is shown for illustrative purposes only and does not predict or depict the performance of the Funds. Indices are unmanaged, include the reinvestment of dividends, and cannot be purchased directly by investors. Past performance does not guarantee future results.
Bonds are subject to interest rate risk and can lose principal value when interest rates rise. Bonds are also subject to credit risk which is the possibility that the bond issuer may fail to pay interest and principal in a timely manner. Issuers of convertible securities may not be as financially strong as those issuing securities with higher credit ratings and are more vulnerable to changes in the economy. If an issuer stops making interest and/or principal payments, these securities may be worth less and the fund could lose its entire investment.
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