Reducing equity sensitivity with convertible bonds

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

After generating strong results over the first nine months of the year, the equity market fell sharply in October. Against a backdrop of sharply higher market volatility, many investors have been looking for potential ports in the storm. While no one can predict the market’s next move, convertible bonds have historically provided the upside potential of stocks and a buffer during market downturns. We recently spoke with Edward Silverstein, Head of Convertibles at MacKay Shields, for his views on the asset class.

Outperforming when volatility increases

Convertibles weren’t immune to the market’s recent decline. However, from a historical perspective, the asset class has outperformed during periods of heightened volatility. This is demonstrated in the chart below. When market volatility, as measured by the CBOE Volatility Index (or “VIX”), surpasses 16, convertibles, as represented by ICE BofAML All U.S. Convertibles Index, have outperformed the S&P 500 Index. This is even more pronounced in months when the VIX ends the month greater than 25.

Convertible bonds have outperformed stocks when volatility spikes higher

Source: Morningstar, as of 9/30/18. Period from 4Q2003 to 3Q2018. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index. Convertibles are represented by the ICE BofAML All U.S. Convertibles Index, and Equities are represented by the S&P 500 Index. Volatility is measured by standard deviation. Index definitions can be found at the end of this report.

Faring well in rising-rate environments

Although the Federal Reserve (Fed) has softened its language regarding its commitment to tightening monetary policy, another increase is expected in December. While this could be a headwind for the bond market (bond prices and rates move in opposite directions), as shown below, convertibles have performed well versus other fixed-income asset classes during periods of rising rates.

Convertible bonds outperform other fixed income securities in rising-rate environments

Gray bars represent periods of rising rates. Table below shows cumulative returns over respective periods.

Blue boxes represent the increase in the 10-year Treasury yield over the time period.

A: 204 bps

B: 159 bps

C: 144 bps

D: 148 bps

E: 154 bps

Convertibles
41.8
Convertibles
8.9
U.S. High Yield
48.3
Convertibles
22.9
Convertibles
12.9
U.S. High Yield
5.7
U.S. High Yield
8.5
Bank Loans
43.1
U.S. High Yield
9.5
U.S. High Yield
6.9
Bank Loans
4.8
Bank Loans
5.8
Convertibles
41.8
Bank Loans
6.4
Bank Loans
5.6
Investment Grade Corporates
(0.1)
Investment Grade Corporates
2.1
Investment Grade Corporates
18.5
Investment Grade Corporates
0.6
Investment Grade Corporates
0.5
Core Bonds
(0.2)
Core Bonds
2.1
Core Bonds
6.7
Core Bonds
(1.1)
Core Bonds
(0.6)
U.S. Treasuries
(1.7)
U.S. Treasuries
1.2
U.S. Treasuries
(1.1)
U.S. Treasuries
(2.3)
U.S. Treasuries
(1.8)

Source: Morningstar as of 9/30/18. Convertibles are represented by the ICE BofAML All U.S. Convertibles Index; Core Bonds are represented by the Bloomberg Barclays U.S. Aggregate Bond Index; Bank Loans are represented by the S&P/LSTA Leveraged Loan Index; Investment Grade Corporates are represented by the ICE BofAML U.S. Corporate Index; U.S. High Yield are represented by ICE BofAML U.S. High Yield Index; and U.S. Treasuries are represented by the Bloomberg Barclays U.S. Treasury Index. The periods of rising rates shown above are based on periods of rising 10-year Treasury yields. Performance for periods greater than a year has been annualized. Period A: 11/1/98-1/31/00, Period B: 7/1/03-6/30/06, Period C: 1/1/09-4/30/10, Period D: 8/1/12-12/31/13, and Period E: 8/1/16-9/30/18. Past performance is not indicative of future results. It is not possible to invest directly into an index. Index definitions can be found at the end of this report.

All cap diversification

In addition to the diversification that convertible bonds have with the overall fixed income market, they also provide diversification from a market capitalization perspective. That’s because convertible bonds are issued by small-, mid- and large-capitalization companies. Furthermore, they come from companies in a wide variety of industries.

Convertibles showed strength during heightened equity volatility

Breakdown by size as of September 30, 2018

Source: Merrill Lynch Convertible Research. The information is hypothetical and not representative of any specific investment. Delta is the ratio comparing the change in the price of underlying assets to the corresponding change in the price of a derivative.

Issue selection is critical

It’s important to note that not all convertible bonds are created equal. In our view, it’s important to “kick the tires” and conduct extensive research of individual securities. In particular, we look to see if the issuing company is financially solid, with a balance sheet that will allow it to meet its future debt obligations. We also favor higher quality companies with strong management teams, as well as those with growth catalysts that may lead to capital appreciation potential.

A cautiously optimistic outlook

While the market’s October downturn was unsettling, we believe the underlying factors that have driven solid performance for the convertible market remain in place. To be sure, there have been signs that global economic growth is moderating. And trade wars concerns remain on the front burner. That being said, we believe the prospects for a U.S. recession over the next one or two years is fairly unlikely. In addition, while rates are likely to rise in the future, convertible bonds have historically performed well in such environments. Finally, we believe new convertible issuance will remain solid, allowing numerous opportunities to invest in compelling securities—if you know where to look.

Past performance is no guarantee of future results, which will vary. All investments are subject to market risk and will fluctuate in value.

This material represents an assessment of the market environment as at a specific date; is subject to change; and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any issuer or security in particular.

The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective.

This material contains general information only and does not take into account an individual’s financial circumstances. This information should not be relied upon as a primary basis for an investment decision. Rather, an assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial advisor before making an investment decision.

Definitions:

The 10-year Treasury note is a debt obligation issued by the United States government with a maturity of 10 years upon initial issuance. A 10-year Treasury note pays interest at a fixed rate once every six months and pays the face value to the holder at maturity.

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.

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.

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 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 Bloomberg Barclays US Treasury Index measures US dollar-denominated, fixed-rate, nominal debt issued by the US Treasury. Treasury bills are excluded by the maturity constraint, but are part of a separate Short Treasury Index.

ICE BofAML US High Yield Index – The index tracks the performance of below-investment-grade U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market.

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/LSTA Leveraged Loan Index is a broad index designed to reflect the performance of U.S. dollar facilities in the leveraged loan market.

Standard deviation – A measure of the dispersion of a set of data from its mean. The more spread apart the data, the higher the deviation. Standard deviation is calculated as the square root of variance. In finance, standard deviation is applied to the annual rate of return of an investment to measure the investment’s volatility.

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.

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.”

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 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, New York 10010, provides investment advisory products and services. NYLIFE Distributors LLC is 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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