Diversifying a portfolio with convertibles
With the possibility of being in the latter stage of the economic cycle, coupled with above average valuations, investors worried about an increase in volatility may be looking to lower their equity exposure and increase their allocation to bonds. At the same time, the prospect of rising interest rates has taken some of the luster out of the bond market. Against this backdrop, it may be prudent to consider diversifying a portfolio with convertible bonds. We recently checked in with Edward Silverstein, CFA, Senior Managing Director, Head of Convertibles, at MacKay Shields. MacKay Shields sub-advises MainStay MacKay Convertible Fund . He discussed the recent performance of convertible securities and MacKay Shields’ views on the asset class.
A convertible bond is a type of bond that the owner can convert into a specified number of shares of common stock in the issuing company. Generally speaking, convertible securities give investors the income stream of bonds, plus the growth potential of stocks, with historically less equity risk. With a convertible, a company can issue debt for less interest expense than straight debt, and investors receive that lower income in exchange for the potential to convert the bond into stock at a later date. If an investor does not convert the bond into stock, they still get their interest payment and principal at maturity.
Convertibles leading the way
Through the first five months of the year, convertibles have outperformed both the broad U.S. stock market and the overall bond market. This has been partially driven by the strong results from small- and mid-caps and from the information technology (IT) sector—the latter represents approximately a third of the total convertible market. We’ve seen the IT sector significantly outperform the S&P 500 Index, driven by overall strong earnings.
Total return, YTD
Source: NYLIM and Morningstar, as of 6/20/18. Past performance is no guarantee of future results. It is not possible to invest directly in an index.
Positive supply/demand technicals
Also supporting the convertible market has been robust supply that has been well absorbed by investor demand. Through the end of May, there has been $27 billion of new convertible issuance, which would put us on track for $55 to $60 billion in 2018 as a whole. This is a significant amount given that the size of the overall convertible market is roughly $190 billion. It’s important to have a healthy amount of new issuance, as convertible bonds regularly mature or are called away.
While valuations in certain segments of the equity market are rich from a historical perspective, we view convertibles to be fairly valued. And, we expect this to remain the case as the year progresses given strong investor demand. Convertible valuations are calculated by the sum of its two parts: the present value of the cash stream of the bond and the value of the imbedded call option. Combining these numbers gives you the theoretical value of an individual bond. The BofA Merrill Lynch All U.S. Convertibles Index is currently trading right around fair value, versus being about 1% overvalued earlier in the year. For comparison purposes, the convertible market has historically traded at a 1½% discount to fair value.
Low correlation to the bond market
While they are technically bonds, over time convertibles tend to perform more like stocks than bonds. This is demonstrated in the table below that shows the correlations between convertibles, stocks, and bonds. This is an important consideration for investors who are concerned about the negative impact on their bond holdings should interest rates continue to move higher.
Correlation with convertible securities
|Asset class||Correlation (1/1/98 – 12/31/17)|
|U.S. mid-capitalization stocks||0.90|
|U.S. small-capitalization stocks||0.86|
|U.S. large-capitalization stocks||0.84|
|U.S. corporate bonds||0.35|
Source: Morningstar, 1/1/98 – 12/31/17. Convertible securities are represented by the ICE Bank of America Merrill Lynch U.S. Convertible Index; U.S. large-capitalization stocks are represented by the S&P 500® Index; U.S. mid-capitalization stocks are represented by the Russell Midcap® Index; U.S. small-capitalization stocks are represented by Russell 2000® Index; Treasury bonds are represented by the ICE BofAML U.S. Treasury Master Index; U.S. corporate bonds are represented by the ICE BofAML U.S. Corporate Master Index; Treasury bills represented by the ICE BofAML US 3-Month Treasury Bill Index; International stocks represented by the Morgan Stanley Capital International (MSCI) Europe, Australasia, and Far East the (EAFE) Index. Index definitions can be found at the end of this blog post.
Credit analysis and fundamental research is critical
The overall U.S. convertible bond market represents more than 400 issues. However, it’s important to note that around half of these securities are not rated. As such, it can be difficult for individual investors to accurately determine the creditworthiness of these issuers. In our view, this demonstrates the importance of investing in convertibles with a professional manager that has the resources to thoroughly analyze individual securities. In particular, we believe it’s critical to have a clear understanding of an issuer’s underlying fundamentals, including its free cash flow, leverage and future business prospects.
The convertible bond market has generated strong results this year and demand for the asset class has been robust. We believe convertibles represent an attractive opportunity for investors to diversify their portfolio and participate in the potential upside of the stock market, with less downside risk. In addition, convertibles tend to perform relatively well in rising interest rate environments.
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.
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 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.
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.
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.
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.
An embedded option is a special condition attached to a security and, in particular, a bond, that gives the holder or the issuer the right to perform a specified action at some point in the future. An embedded option is an inseparable part of another security, and as such does not trade by itself. Nevertheless, it can affect the value of the security of which it is a component.
ICE BofAML U.S. Convertible Index – an unmanaged market capitalization-weighted index of domestic corporate convertible securities that are convertible to common stock only.
ICE BofAML U.S. Corporate Master Index tracks the performance of investment grade corporate debt publicly issued in the U.S. Qualifying securities must have at least one year remaining term to final maturity, a fixed coupon schedule and a minimum amount outstanding of $250 million.
ICE BofAML U.S. 3-Month Treasury Bill Index is comprised of a single issue purchased at the beginning of the month and held for a full month. At the end of the month that issue is sold and rolled into a newly selected issue.
ICE BofAML U.S. Treasury Master Index tracks the performance of sovereign debt publicly issued by the U.S. government in its domestic market. Qualifying securities must have at least one year remaining term to final maturity, a fixed coupon schedule and a minimum amount outstanding of $1 billion.
Morgan Stanley Capital International (MSCI) Europe, Australasia, and Far East the (EAFE) Index – an unmanaged, capitalization-weighted index containing approximately 985 equity securities of companies located outside the United States
Russell Midcap® Index – an unmanaged index that measures the performance of the 800 smallest companies in the Russell 1000® Index.
Russell 2000® Index – an unmanaged index that measures the performance of the 2,000 smallest companies in the Russell 3000® Index.
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 Investments engages the services of MacKay Shields LLC, an affiliated, federally registered advisor, to subadvise several mutual funds. 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.