Looking Under the Hood of Convertibles’ Strong Results
The stock market reached a new all-time high at the end of the third quarter. With the bull market now at 8+ years—the second longest on record—investors may be looking to take some chips off the table. At the same time, the bond market could be vulnerable as the Federal Reserve (the Fed) is poised to further tighten monetary policy. So, where can investors turn? We recently checked in with Edward Silverstein, CFA, Senior Managing Director, Head of Convertibles, at MacKay Shields. MacKay Shields sub-advises MainStay Convertible Fund.
How High Can It Go?
The stock market’s resilience this year continues to surprise many financial pundits. Despite disappointment regarding the trajectory of some of President Trump’s growth initiatives, natural disasters, and geopolitical issues, the market continues to churn higher. Investors who fled risk assets, fearing an end to the lengthy bull market, have missed out on some heady gains. Still, it may be prudent to hedge one’s bets. And, convertible bonds could be the answer.
Convertibles 101: Hitting the “Sweet Spot”
A convertible is a hybrid security that includes the features of both stocks and bonds in a single investment. Convertible securities provide investors with the income stream of bonds, plus the growth potential of stocks. A type of bond issued by a company, a convertible security can be converted into a predetermined number of shares of common stock. Given today’s equity valuations, convertibles are a way to maintain some equity exposure and help minimize some downside participation in the event of a market correction.
Riding the Wave
While convertible securities are a more conservative investment than pure equity exposure, they’ve posted strong results thus far in 2017. Through the first nine months of the year, convertibles, as measured by the Bank of America Merrill Lynch U.S. Convertible Bond Index, have gained 11.96%, versus a 14.24% return for the S&P 500 Index. Meanwhile, the bond market, as measured by the Bloomberg Barclays U.S. Aggregate Bond Index, is up a mere 3.14%.
Convertible Performance YTD vs. Stocks and Bonds
Source: Morningstar Direct, as of 9/30/17. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.
Looking Under the Hood
By taking a closer look at the convertible market, we can see that a portion of its ascent has been driven by its exposure to technology. At a 35% weighting, technology remains the largest sector in the convertible market. But, unlike the concentration of the “FAANG” (Facebook, Apple, Amazon, Netflix, and Alphabet’s Google), convertible issuance from technology companies is diversified among a large swath of industries, including hardware, software, internet-related, and peripherals, to name a few.
Avoiding the Headwinds
At the other end of the spectrum, the convertible market has relatively low exposure to two areas of the market that have underperformed this year: retail and energy. The “Amazon effect” continues to pressure traditional brick-and-mortar retail companies. Yet, retail is less than 2% of the convertibles index. Until recently, energy has been one of the stock market’s laggards. But, at less than a 6% weighting, energy hasn’t had a large impact on the convertible market.
Source: Bank of America Merrill Lynch Global Convertibles Chartbook, as of 10/17. Sectors are represented by sector allocation of the Bank of America Merrill Lynch U.S. Convertible Bond Index.
New Issuance/Less Equity Sensitivity
Another sign of health in the convertible market is demonstrated by strong new issuance volume—a trend we expect to continue. When new convertible issues come to the market, they are usually priced at par, and are generally “balanced” convertibles, meaning that they have a fair measure of equity sensitivity, but also offer a degree of downside protection. This year, a number of large convertibles that were very equity-sensitive and were trading at 500-600% of par value matured or were redeemed by their respective issuers. Their removal from the convertibles index and the addition of new, balanced securities has helped lower the overall equity sensitivity of the benchmark. The average convertible bond price is now about 115, compared to 120 a year ago.
Equity Sensitivity (Delta)
Source: Bank of America Merrill Lynch Global Convertibles Chartbook, as of 10/17. Delta is the measure of the sensitivity of a convertible bond’s price to changes in the underlying equity’s price.
Convertibles allow investors to seek the sweet spot of the market, with the ability to participate in the potential upside of equities with historically less volatility. At the same time, convertibles have a negative correlation to U.S. Treasury bonds. As such, convertibles have historically performed well in rising rate environments. We believe this makes convertibles a compelling opportunity, given today’s market environment.
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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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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.
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 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 U.S. Aggregate Bond Index is a broad-based benchmark that measures the investment-grade, U.S. dollar-denominated, fixed-rate taxable bond market, including Treasuries, government-related and corporate securities, mortgage-backed securities (agency fixed-rate and hybrid adjustable-rate mortgage pass-throughs), asset-backed securities, and commercial mortgage-backed securities.
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.
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New York Life Investment Management LLC engages the services of federally registered advisors. MacKay Shields LLC is an affiliate of New York Life. 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.