Convertible securities are hybrids that have stock-like and bond-like qualities. Where do they belong in portfolios?
Most investors use convertibles as a proxy for common stocks. By definition, they are corporate bonds that can be “converted” into a company’s stock, which means they can take on characteristics of stocks or bonds. Converts tend to appreciate like a stock when stock prices are rising and protect like a bond when stocks are falling. Since 1988, they've captured 80% of the upside return of the S&P 500 Index and only 66% of the downside volatility (see chart). That shows the “asymmetric” risk/reward profile of convertibles: upside participation with downside protection.
Despite having a higher correlation to equities, some investors use convertibles to diversify their core-bond allocations, in large part because these securities are less sensitive to rising interest rates. Others use converts in their “opportunistic” allocations because of the asymmetric risk/reward profile they provide.
Solid Performance in Up and Down Markets
Convertibles have historically participated in a significant portion of the upside potential of stocks while limiting exposure to downside volatility.
Source: BofA Merrill Lynch; Factset. Data from 1/1988–3/2013 (quarterly). Chart shows performance of BofA ML All Convertibles All Qualities Index versus that of the S&P 500. Past performance is no guarantee of future results.
Some market watchers are predicting higher interest rates in the next few years. How will convertibles behave?
History shows that in rising interest-rate environments, convertible bonds tend to outperform Treasuries and core bonds. Unlike any other investment, Treasuries have US government-guaranteed interest and principal repayments—but Treasuries are also very rate-sensitive. Because rates generally rise when business and economic conditions are robust, and because convertibles are stock-like when stock prices rise, both stocks and converts tend to perform well in rising-rate environments. During the four periods of rising rates since 1988, they outperformed high-quality bonds by an average of 6.61 percentage points—and outperformed Treasuries by an average of 8.04 percentage points.
A Cushion Against Rising Rates
Over four rising-rate periods, convertibles outperformed core bonds and Treasuries by an average of 6.61 and 8.04 percentage points, respectively.
||Rising-Rate Cycle 1: 3/29/88 to 2/24/89
||Rising-Rate Cycle 2: 2/4/94 to 2/1/95
||Rising-Rate Cycle 3: 6/30/99 to 5/16/00
||Rising-Rate Cycle 4: 6/30/04 to 6/29/06
|Total Rate Hike
Source: Morningstar Direct. Core bonds are represented by the Barclays US Aggregate Index and convertibles by the BofA Merrill Lynch All Convertibles All Qualities Index. Past performance is no guarantee of future results.
New issuance of convertibles was off last year. Is this year’s level any different and why does it matter to investors?
The amount of new issuance—the total amount of new convertible bonds for sale in the marketplace—turned around in 2013. Compare the $21 billion in new issuance during the full year of 2012 with the $12 billion from just the first three months of 2013. This is clearly a positive trend that speaks to an increasing demand for and supply of convertible debt, which is good news for investors. We’re also seeing a shift in how companies are using the proceeds from this new issuance. From 2010 through 2012, new issuance was primarily used to refinance outstanding debt. But from late 2012 through early 2013, most new issuance has centered on raising money for growth—including financing for mergers, acquisitions and capital expenditures to help companies grow. We believe this speaks to today’s more robust economic climate, which is yet another good sign for convertibles.
With so many issuers not rated by a major credit rating agency, how do you judge credit quality?
According to Bank of America Merrill Lynch, around 35% of the convertible market is currently not rated. A majority of these companies are first-time corporate-debt issuers that don’t want to pay a major rating agency to formally rate their bonds. But as part of our investment process, we calculate our own objective, internal credit ratings for convertible securities in our investment universe—whether or not they’re rated by third parties. For rated issues, this step enables us to compare the agencies’ published ratings with our own and identify a potential upgrade candidate. For unrated issues, it helps us evaluate what the debt should be rated. Credit research and credit modeling are essential to our investment process.
Given the current market environment, why does it make sense to invest in convertibles?
We remain constructive on the convertible market. Earnings for the fourth quarter of 2012 generally met or exceeded expectations, and issuers’ 2013 earnings outlooks were positive. Corporate balance sheets remain strong, with leverage ratios and interest-coverage ratios consistent with—or better than—the average levels we’ve seen over the past 20 years. In addition, corporate balance-sheet cash levels remain high, and we expect companies to use both that cash and future free cash flow to boost shareholder value via share buybacks, dividends, and merger and acquisition activity. These factors should benefit equity and convertible investors. Overall, the positive asymmetric risk/reward profile of converts is very favorable, especially during periods of high volatility. We believe a strategic allocation to convertibles makes sense for investors who are looking to participate in the upside of the equity markets while protecting on the downside, and for investors concerned about rising rates.