Convertibles and Tech Continue a Low-Vol Romance

by:
Director, Product Management, MainStay Investments

For investors, convertibles represent the possibility of equity upside participation alongside some help in managing downside volatility. Over the last several years, convertible performance has been strong and has, in fact, provided investors equity-like upside returns with lower volatility. In 2016, convertible bonds, as defined by the Bank of America Merrill Lynch U.S. Convertibles Bond Index, returned 10.43%, capturing 87% of the 11.96% return of the S&P 500 Index. Over the first half of 2017, convertibles returned 7.89% — 84% of the 9.34% return of the S&P 500. Over the same period, the asset class has also outperformed core bonds, high-yield bonds, bank loans, small-cap stocks, and mid-cap stocks.1

While investors were hopeful that the new administration’s economic priorities including corporate tax reductions and less regulation would materialize, the Trump-fueled enthusiasm has stalled, amid uncertainty surrounding policy. Despite the change in sentiment, the convertible bond and equity markets continued their low-volatility advance during the second quarter and extended the rally that took hold in the wake of November 8, 2016.

New Issuance Heavyweight

The past several years have marked a resurrection of a vibrant market for new issuance, which has continued in the first half of 2017 with $26 billion of new issues, of which over $8 billion is technology-related. Not only is technology leading new issuance, it is also the largest sector, representing 35% of the market and, therefore, can be considered the most important sector in the convertible bond universe.2

Figure 1: Technology Leads Convertible Sector Weights

Weighting within Convertibles Universe as of 6/30/17

Source: BofA ML Chartbook, 7/5/17. Data as of 6/30/17. Chart created by New York Life Investment Management.

Why Is Technology Such a Significant Component of the Convertibles Universe?

Let’s look at it from the issuer’s perspective: Often times, a newer company needs to raise capital, but doesn’t want to be saddled with debt and a high interest expense (these companies are usually issuing below investment-grade instruments, and as such, would have to pay a higher yield). A convertible bond allows the company to issue debt with a lower coupon, due to the embedded option (conversion feature), which may have value to an investor. Additionally, if and when a convertible bond gets converted into common stock, it is done so at a higher price than where the stock is currently trading, meaning less new shares are issued to raise the same amount of capital and shareholders are less diluted.

By that rationale, convertibles may seem like a good deal for any issuer, so why is tech such a dominant issuer? The answer is that volatility and option prices are directly related, meaning that an increase in volatility of the underlying stock will increase the value of the option. It follows that an option on a tech company would be more valuable than an option on a utility, all else being equal, since tech stocks tend to exhibit greater volatility than utilities. Therefore, an investor is willing to pay a greater conversion premium on that convertible bond for the more volatile company. In other words, the company can issue the security farther “out of the money” for a company with greater implied volatility. Since technology tends to be a more volatile sector, the convertibles market may offer more favorable financing terms to tech issuers, as compared with issuers from less volatile sectors.

What Does the Tech Weighting Mean for Investors?

The convertibles asset class provides investors a way of playing a very volatile sector in a more risk-controlled manner. As with any sector in the asset class, convertibles may allow for upside equity participation with less volatility. However, the bond-like characteristics of the par-value floor are more meaningful for more risky securities. Additionally, the tech sector within converts is fairly diverse across market caps, credit quality, and profile (equity sensitive vs. rate sensitive) and includes household names, such as Intel, Zillow, and Priceline.com.2

Tech exposure via the converts asset class has paid off for investors, as YTD, not only has the sector outperformed the broader convertibles market, but it has outperformed the S&P 500 as well. It’s worth noting that the underlying equities of tech convertibles have outperformed the S&P Select Tech Index3 (subset of the S&P 500) by 300 bps YTD as of 6/19/17, as illustrated in Figure 2 below.4

Figure 2: Underlying Tech Equities of Convertibles Have Outperformed

YTD Performance as of 6/19/17

Source: Barclays Research, as of 6/19/17. US Cvts – All is represented by Barclays US Convertible Bond Index; US Cvts – Tech is represented by Barclays Convertible Technology Index; US Cvts – All Underlyings is represented by Barclays US Convertible All Underlying Index; US Cvts – Tech Underlying is represented by Barclays Convertible Technology Underlying Index; SPX is represented by the S&P 500 Index; SPX Tech Index is represented by the S&P Select Tech Index; R2000 is represented by the Russell 2000 Index; R2000 Tech Index is represented by the Russell 2000 Tech Index; HY is represented by the Bank of America Merrill Lynch US HY Master II Constrained Index; IG is represented by Bloomberg Barclays US Corporate Bond Index; and 5-7Y Treasurys is represented by the Bloomberg Barclays US Treasury 5-7 Year Index.

Conclusion

While we previously discussed reasons convertibles may make sense during rising rate environments, seeing its utility in a universe as diverse, important, and potentially volatile as tech only makes convertible bonds more compelling.

1. Core bonds are represented by the Bloomberg Barclays US Aggregate Bond Index. High Yield is represented by the Bank of America Merrill Lynch US HY Master II Constrained Index. Bank Loans are represented by the S&P/LSTA Leveraged Loan Index. Mid-cap stocks are represented by the S&P MidCap 400 Index. Small-cap stocks are represented by the Russell 2000 Index.

2. Bank of America Merrill Lynch Global Convertibles Chartbook, 7/5/17.

3. The S&P Select Tech Index is also a constituent of the S&P 500. All components of the S&P 500 are assigned to at least one of 11 Select Sector Indices, which track major economic segments and are highly liquid benchmarks. Stock classifications are based on the Global Industry Classification Standard (GICS)

4. Barclays, “The Rise and Rise of Tech Converts – An Attractive Vehicle for Tech Investing” 6/21/17.

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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About Risk:

Convertible Securities – 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.

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.

The Bloomberg Barclays US Corporate High Yield Bond Index measures the USD-denominated, high yield, fixed rate corporate bond market.

Securities are classified as high yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below. Bonds from issuers with an emerging markets country of risk, based on the indices’ EM country definition are excluded. The US Corporate High Yield Index is a component of the US Universal and Global High Yield Indices.

The Bloomberg Barclays US Corporate Bond Index measures the investment-grade, fixed rate, taxable corporate bond market. It includes US-denominated securities publicly issued by US and non-US industrial, utility and financial issuers.

The Barclays US Convertible Bond Index tracks the performance of USD denominated convertibles market and includes all major classes of convertible securities. These bonds offer upside participation with an equity component and downside protection with a fixed income component.

The Bloomberg Barclays US Treasury 5-7 Year Index measures the performance of US dollar-denominated, fixed rate nominal debt issued by the US Treasury with remaining years to maturity between 5 and 7 years.

The S&P 500 Index is widely regarded as the best single gauge of large-cap US equities. The index includes 500 leading companies and captures approximately 80% coverage of available market capitalization.

The S&P Select Tech Index is also a constituent of the S&P 500. All components of the S&P 500 are assigned to at least one of 11 Select Sector Indices, which track major economic segments and are highly liquid benchmarks. Stock classifications are based on the Global Industry Classification Standard (GICS).

The Barclays US Convertible Bond Index tracks the performance of USD denominated convertibles market and includes all major classes of convertible securities. These bonds offer upside participation with an equity component and downside protection with a fixed income component.

The Barclays US Convertible All Underlying Index tracks the performance of the common stocks represented by the Barclays US Convertible Index.

The Barclays Convertible Technology Index is a subset of the Barclays US Convertible Bond Index and includes constituents that are in the technology sector.

The Barclays Convertible Technology Underlying is a subset of the Barclays US Convertible Bond Index and includes the common stock of convertible constituents that are in the technology sector.

The Russell 2000 Index is an index measuring the performance approximately 2,000 small-cap companies in the Russell 3000 Index, which is made up of 3,000 of the biggest U.S. stocks. The Russell 2000 serves as a benchmark for small-cap stocks in the United States.

The Russell 2000 Tech Index is a subset of the Russell 2000 Index which includes companies in the technology sector.

For more information about MainStay Funds®, call 800-MAINSTAY (624-6782) for a prospectus or summary prospectus. Investors are asked to consider the investment objectives, risks, and charges and expenses of the investment carefully before investing. The prospectus or summary prospectus contains this and other information about the investment company. Please read the prospectus or summary prospectus carefully before investing.

MainStay Investments® is a registered service mark and name under which New York Life Investment Management LLC does business. MainStay Investments, an indirect subsidiary of New York Life Insurance Company, New York, NY 10010, provides investment advisory products and services. Securities are distributed by NYLIFE Distributors LLC, located at 30 Hudson Street, Jersey City, NJ 07302. NYLIFE Distributors LLC is a Member FINRA/SIPC.

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Adam Schrier, CFA, FRM

Director, Product Management, MainStay Investments

Adam Schrier is a Director of Product Management at MainStay Investments covering taxable fixed income and energy equity strategies. Previously, he worked as a Product Manager for high yield and emerging market debt at Invesco in New York

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