A false spring for convertible bonds?

Market shifts may make them less appealing. Active managers are finding more attractive income options.

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Key takeaways

  • Bonds that can be converted to shares of stock have attracted lots of interest from investors so far this year, but the convertible market is becoming more challenging to navigate.
  • Multi-asset income strategies may help investors meet their needs for income as the performance of various asset classes varies over time.
  • Besides convertible bonds, dividend-paying value stocks, high-yield bonds, floating-rate debt, master limited partnerships, and real estate investment trusts may also offer income opportunities, albeit with higher potential volatility than more familiar fixed income assets.

With the economy emerging from recession, the November elections in the rear-view mirror, and hope rising for COVID-19 vaccines, many investors may look forward to 2021. But for those who focus on income, the future may look less bright. While the S&P 500 hit record highs in 2020, interest rates are near record lows and income seekers may doubt there are alternatives to pricey and potentially volatile stocks.

The good news is, despite low rates, opportunities exist for those who know where to look and how to manage the risks of doing so. In 2021’s environment, a professionally managed, tactical approach to income investing that seeks opportunities in a variety of asset classes may help investors achieve their income goals.

Convertibles: pluses and minuses

In an environment of low interest rates and high stock prices, convertible bonds have looked attractive because they not only pay interest, they also reduce some of the potential drawbacks of both stocks and longer-duration bonds. Among their pluses:

  • Less volatility. While convertible bond prices can fall if interest rates rise and stock prices decline, they are less sensitive to such changes than both stocks and traditional corporate bonds, though more sensitive than Treasurys.
  • Growth potential. Convertibles offer the potential for capital appreciation from their underlying stocks.
  • Downside protection. In bankruptcy, convertible bondholders get paid before stockholders, but after some other holders of debt.
  • Hedges against inflation and rising rates. While the increasing prospect of future inflation and higher interest rates poses risks for longer duration bonds, the ability to convert those bonds to stock helps reduce worries about rate risk, though higher rates may also negatively impact stock prices.
  • Attractive pricing. Convertibles may help allay concerns about buying otherwise attractive stocks at very high prices because the price at which they can be converted to stock has been determined in advance.

Technology and health care companies have long issued convertible bonds. Many of these companies’ stocks, such as those of Tesla and NextEra Energy, have risen significantly and convertible bonds have provided an attractive way to get exposure to them. Recently, many companies from a wide variety of industries have also issued convertible bonds for the first time.

But before you join them and jump into convertibles, remember that the convertible bond market is both small and specialized, and conditions in it can change quickly. This is because unlike other asset markets, the makeup of the convertible market is constantly changing as existing bonds get converted to stock and leave the market while new bonds with different features take their place.

Since the start of the year, for example, many issuers have responded to surging interest from investors by slashing the interest payment or “coupon” on new bonds, often all the way to zero. Meanwhile, the market’s sensitivity to changes in stock prices remains well above its 25-year average. That combination of relatively high risk and low interest payments suggests that the convertible market is currently offering fewer benefits for investors than it might have historically and less than they might be expecting.

A lesson for investors

These rapid changes in the types of convertible bonds available and the interest they pay show how the forces that drive markets are always in motion. Because market conditions constantly change, the investments that deliver the highest returns today may not be the ones that do so next month or next year. That’s why diversification, research, and risk management matter.

Multi-asset income strategies that can invest across a wide variety of asset classes may be able to deliver more consistent returns and a better balance between risk and return than those with fewer options to choose from, such as ones that may rely too heavily on convertible bonds.

Looking elsewhere for income opportunities?

While convertible bonds certainly can continue to play a role for investors, there are some alternatives.

US and international dividend-paying value stocks are paying healthy dividends and may be less potentially volatile than other stocks, though more volatile than corporate or Treasury bonds. They’re also inexpensive by historical standards because investors have focused on growth stocks and have been willing to pay a premium for them. Attractive opportunities may exist in a variety of industries including leisure and travel, financials, industrials, materials, oil tankers, energy, semiconductors, and non-bank financial firms.

High-yield bonds offer higher interest payments than those offered by Treasurys or investment-grade bonds, and valuations appear relatively reasonable. Of course, their higher interest payments reflect their lower credit ratings and imply a higher risk of default. But the credit quality of the overall high-yield market is actually higher now than it was a year ago as many profitable and well-managed companies, such as Ford and Occidental Petroleum, have seen their credit ratings lowered into high-yield territory. High-yield bonds also are less exposed to another risk of income investing, the possibility that rising interest rates will reduce bonds’ prices.

Floating-rate debt in the form of secured term loans is another source of opportunity. Many of these loans are trading below par, but they offer low sensitivity to changing interest rates and yields that may rise and fall. Remember, like high-yield bonds, these are sub-investment grade assets that may be more volatile and present higher credit risk.

Real estate investment trusts in the US and Canada may also offer attractive and steady dividends and also the potential for capital appreciation as more people are vaccinated and return to offices, stores, and leisure activities.

Master limited partnership (MLP) dividends are another interesting source of income, though investing in them is also best left to professional managers. These companies mostly operate oil and gas pipelines and other energy industry investments. MLPs could benefit if tax rates go up because as partnerships, rather than corporations, they have tax advantages that would become increasingly valuable in a higher tax environment.

Finding ideas

Investors interested in these strategies should research professionally managed mutual funds or separately managed accounts. You can run screens using the Mutual Fund Evaluator on Fidelity.com. Below are the results of some illustrative mutual fund screens (these are not recommendations of Adam Kramer or Fidelity).

Multi-asset class income funds

Fidelity funds
Fidelity® Multi-Asset Income Fund (FMSDX)

Non-Fidelity funds
BlackRock Multi-Asset Income Portfolio (BAICX)
Invesco Multi-Asset Income Fund (PIAFX)

Separately managed accounts
BlackRock Diversified Income Portfolio

The Fidelity screeners are research tools provided to help self-directed investors evaluate these types of securities. The criteria and inputs entered are at the sole discretion of the user, and all screens or strategies with preselected criteria (including expert ones) are solely for the convenience of the user. Expert screeners are provided by independent companies not affiliated with Fidelity. Information supplied or obtained from these screeners is for informational purposes only and should not be considered investment advice or guidance, an offer of or a solicitation of an offer to buy or sell securities, or a recommendation or endorsement by Fidelity of any security or investment strategy. Fidelity does not endorse or adopt any particular investment strategy or approach to screening or evaluating stocks, preferred securities, exchange-traded products, or closed-end funds. Fidelity makes no guarantees that information supplied is accurate, complete, or timely, and does not provide any warranties regarding results obtained from its use. Determine which securities are right for you based on your investment objectives, risk tolerance, financial situation, and other individual factors, and reevaluate them on a periodic basis.

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