Convertibles Shine through Clouds of Volatility

by: , Director, Product Management, New York Life Investments

Well, it had to end at some point. For a while in 2017, it seemed like wherever you invested, you would earn a positive return, with very few bumps in the road. While many strategists were calling for a 2018 that looked very much like 2017, the first four months of the year have been anything but. As can be seen in Chart 1, the confetti was barely cleaned up in Times Square, when the VIX spiked to levels not seen since 2015.

Chart 1: After a Prolonged, Low-volatility Environment, the VIX Spiked Sharply in 2018 (VIX Daily)

Source: Bloomberg, 5/1/15 – 4/30/18. An investment cannot be made directly in an index. Past performance is not a guarantee of future results.

Amid increasing volatility and the 10-year Treasury hovering around 3%, both stocks and bonds have stumbled this year, as shown in Chart 2. Interestingly, the asset class that has managed to shine exhibits characteristics of both stocks and bonds. A convertible bond is a hybrid security that consists of a bond and a warrant, which allows an investor to convert the bond into a company’s stock at a predetermined conversion ratio. The appeal of this structure is that it allows an investor to participate in the equity upside, while potentially mitigating downside participation through its bond features. This is described in greater detail in Convertible Bonds: Built for Times Like These.

Chart 2: Convertible Bonds Had Strong Performance YTD vs. Other Classes

Source: Morningstar, as of 4/30/18. Convertibles represented by BofA Merrill Lynch All U.S. Convertibles Index; EM Equity represented by MSCI Emerging Markets Index; EAFE represented by MSCI EAFE Index; US HY represented by BofA Merrill Lynch 0-5 Year US High Yield Constrained Index; Global Agg represented by Bloomberg Barclays Global Aggregate Bond Index; S&P 500 represented by S&P 500 Index; US Agg represented by Bloomberg Barclays U.S. Aggregate Bond Index; EM Debt represented by JPMorgan EMBI Global Diversified Index; US Corps represented by BofA Merrill Lynch US Corporate Index; MLPs represented by Alerian MLP Index. An investment cannot be made directly in an index. Past performance is not a guarantee of future results. Index definitions can be found at the end of this blog post.

If suitable, as advisors and clients reevaluate their asset allocation decisions, convertible bonds may be worth another look. In Chart 3, we look at average monthly returns of convertibles versus stocks (represented by the S&P 500) over the last 20 years. During periods of low volatility, as characterized by months with an ending VIX level of less than 14, equities provide meaningful outperformance versus convertibles. As we look at periods of greater volatility, the relative performance of equities declines, and convertible bonds actually outperformed stocks in months where the VIX ended at a level greater than 19. This is most pronounced in months with an ending VIX level of greater than 25. During these months, both asset classes averaged negative returns; however, convertibles held up fairly well, capturing only 56% of the equity decline.

Chart 3: Convertible Bonds Have Outperformed Stocks during Periods of Heightened Volatility

Sources: Bloomberg and Morningstar, 5/98 – 4/18. Convertibles represented by BofA Merrill Lynch All U.S. Convertibles Index; S&P 500 represented by S&P 500 Index. An investment cannot be made directly in an index. Past performance is not a guarantee of future results. Index definitions can be found at the end of this blog post.

So, what about bonds? Fixed-income investors have been looking to protect against rising rates for years, and it looks like they are finally rising. Since rates tend to rise when the economy is expanding, stable issuer fundamentals often coincide with increasing Treasury yields. Therefore, it comes as no surprise that convertibles have performed well, relative to other fixed-income asset classes during periods of rising rates, as shown in Chart 4.

Chart 4: Convertible Bonds Outperform vs. Other Types of Fixed Income in Rising Rate Environments

Bond Performance during Rising Rate Periods:

Rising Rate Period: A B C D E
Convertibles 29.7 8.0 37.9 20.7 10.9
High Yield 5.7 7.6 48.3 8.5 6.8
IG Corps (0.1) 3.0 18.5 (0.1) 0.7

Sources: Bloomberg and Morningstar, 1/95 – 3/18. Convertibles represented by BofA Merrill Lynch All U.S. Convertibles Index; High Yield represented by BofA Merrill Lynch 0-5 Year US High Yield Constrained Index; IG Corps represented by BofA Merrill Lynch US Corporate Index. An investment cannot be made directly in an index. Past performance is not a guarantee of future results. Index definitions can be found at the end of this blog post.

In a year that has seen increased volatility and rising rates disrupt the calm of 2017, convertible bonds have proven resilient. The notable performance of convertibles makes the asset class worthy of consideration for inclusion in a portfolio, as they may help reduce equity volatility and decrease interest-rate risk. It may not be realistic to reallocate an entire equity or fixed-income allocation to convertibles, but carving out a place for them in a portfolio may help make the bumpy ride a bit smoother.

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. New York Life Investments does not guarantee their accuracy or completeness, nor does New York Life 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.

About Risk

All investments are subject to market risk, including possible loss of principal. There is no assurance that the investment objectives mentioned will be met. Diversification cannot assure a profit or protect against loss in a declining market.

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.

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.

Treasury Securities are backed by the full faith and credit of the United States government as to payment of principal and interest if held to maturity.

Definitions

Alerian MLP Index – The index is a float-adjusted, capitalization-weighted index, whose constituents represent approximately 85% of total float-adjusted market capitalization. This index provides a comprehensive benchmark for investors to track the performance of the energy MLP sector. The majority of MLPs currently operate in the energy infrastructure industry, owning assets such as pipelines that transport crude oil, natural gas and other refined petroleum products. This index is is disseminated real-time on a price-return basis (AMZ) and on a total-return basis (AMZX).

BofA Merrill Lynch 0-5 Year US High Yield Constrained Index – The index is an unmanaged index comprised of U.S. dollar denominated below investment grade corporate debt securities publicly issued in the U.S. domestic market with remaining maturities of less than 5 years.

BofA Merrill Lynch All U.S. Convertibles 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.

BofA Merrill Lynch US Corporate Index – The Index is an unmanaged index comprised of U.S. dollar denominated investment grade corporate debt securities publicly issued in the U.S. domestic market with at least one year remaining term to final maturity.

The Bloomberg Barclays Global Aggregate Bond Index is a flagship measure of global investment grade debt from twenty-four local currency markets. This multi-currency benchmark includes treasury, government-related, corporate and securitized fixed-rate bonds from both developed and emerging markets issuers.

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 conversion ratio is the number of common shares received at the time of conversion for each convertible security . The higher the ratio, the higher the number of common shares exchanged per convertible security . The conversion ratio is determined at the time the convertible security is issued and has an impact on the relative price of the security.

JPMorgan EMBI Global Diversified Index – The index is an unmanaged, market-capitalization weighted, total-return index tracking the traded market for U.S.-dollar-denominated Brady bonds, Eurobonds, traded loans, and local market debt instruments issued by sovereign and quasi-sovereign entities.

The MSCI EAFE Index is an equity index which captures large- and mid-cap representation across Developed Markets countries* around the world, excluding the US and Canada. With 926 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.

MSCI Emerging Markets Index – The index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. The index consists of the following 21 emerging market country indices: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey.

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.

VIX is the ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility Index, which shows the market’s expectation of 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500 index options. This volatility is meant to be forward looking, is calculated from both calls and puts, and is a widely used measure of market risk, often referred to as the “investor fear gauge.”

A warrant is a derivative that confers the right, but not the obligation, to buy or sell a security – normally an equity – at a certain price before expiration.

New York Life Investments® is a registered service mark and name under which New York Life Investment Management LLC does business. New York Life 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, New York Life Investments

Adam Schrier is a Director of Product Management at New York Life Investments, covering fixed income strategies with a focus on non-investment grade debt. Previously, he worked as a Product Manager for high yield and emerging market debt at Invesco in New York

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