With stocks just below all-time highs and bond yields near record lows, many investors are left searching for capital appreciation and current income. There’s one often-overlooked asset class that could satisfy both needs, while insulating investors from a downdraft: convertible bonds.
Issued by a range of companies from Tesla (TSLA) to Bank of America (BAC) to Dish Network (DISH), the securities exhibit beneficial characteristics of both stocks and bonds. Like bonds, convertibles yield regular interest payments and return their principal at maturity. But they also include an embedded option to swap for the company’s stock at a defined price, typically 25% to 30% higher than the stock’s value when the convertible was issued.
The effect is that convertibles trade largely like the issuer’s stock when shares are rising; as the underlying stock’s value increases, so does the value of the option to receive it. But “converts” also have a built-in floor as long as the company doesn’t default—the value of the bond’s coupon payments and principal at maturity.
Alan Muschott, lead manager of the Franklin Convertible Securities fund (FISCX), calls convertible bonds “equities with training wheels.” He looks for converts that typically capture 75% of the upside of stocks but only 50% of the downside.
“You don’t get all the equity upside, but you can only fall so far because you have the downside protection of the bond,” Muschott says. “With a convertible, absent a default, at maturity you get your money back. So really your only cost over the long term is your opportunity cost, because you’re not earning as much as straight debt.”
Take last year, when the Bloomberg Barclays U.S. Convertibles index, which captures the performance of more than $200 billion of the U.S. converts market, fell 2%. The index trailed the equities market through the fall as stocks soared, but didn’t fall nearly as much in the fourth quarter as stocks tumbled. The S&P 500 index (.SPX) ended 2018 off 4.4%, after dividends, while the Bloomberg Barclays U.S. Aggregate Bond index was flat.
In fact, since 1973, converts have outperformed the S&P 500 by an average of 2.6% annually, while registering a beta—or volatility relative to the index—of 0.73. That trend of outpacing the market with lower volatility has been true over much of the past decade as well.
The securities have even outperformed a 60/40 stock and bond portfolio. Research by convertible-focused Advent Capital Management shows that over the past two decades, the classic balanced portfolio trailed a portfolio of convertible bonds by almost 2% per year with a similar level of volatility.
Converts can also offer investors a way to play highflying growth stocks while keeping their risk at manageable levels. Many convertible-bond issuers are higher-growth companies such as Etsy (ETSY), Square (SQ), and Salesforce.com (CRM).
“You can basically have a ‘growthy’ set of stocks but a beta and income profile like an equity income fund,” says David King, manager of the Columbia Convertible Securities fund (PACIX). “There are a lot of older and conservative investors whose portfolios have a value bias—not because they’re value investors, [but because] they just want lower volatility and more income. So convertible funds are extremely useful in diversifying those portfolios and providing a growth-stock exposure that’s acceptable from an income and volatility perspective.”
The drawback for many investors is that most convertibles are privately placed and can only be traded by qualified institutional buyers, according to the Securities and Exchange Commission. That makes convertible-bond funds the only option for most people. The largest passive exchange-traded fund, SPDR Bloomberg Barclays Convertible Securities (CWB), is up 14% this year.
Many active managers tend to do better by focusing on the middle of the field of converts, so-called balanced convertibles, whose companies’ shares trade relatively close to their conversion price. “Busted” convertibles are those with a stock price far below conversion, and typically trade just like straight bonds, while “in the money” converts are at or above conversion and behave like a stock. Balanced convertibles are preferable, according to Advent founder and Chief Investment Officer Tracy Maitland, because of the positive asymmetry they possess—capturing more of the upside than the downside of equities.
Converts’ defensive attributes look particularly attractive today. This year’s rising stock market and tumbling bond yields have left valuations in both asset classes challenging, while the market could break out in either direction depending on how questions about economic conditions, trade wars, and monetary policy are resolved.
“I think this is one of the best environments for convertibles, and in fact the level of dialogue we’re having now [with potential investors] is greater than we’ve had in quite some time,” says Maitland. “People are a bit nervous right now, and geopolitical issues keep rocking the market.…If you can have a strategy where you can still preserve upside participation as the market continues to go up but have significantly superior downside protection, why wouldn’t you do it?”
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