Convertibles: A Smoother Ride When the Road Gets Bumpy

We recently got together with portfolio manager Edward Silverstein, of the MacKay Shields' Convertible Bond Team who advises a 2016 Lipper Funds' award-winning fund1. It was the first time we caught up since the June 23 Brexit vote, a referendum on remaining in the European Union (EU) which caught investors by surprise. By a 52%-48% margin, British voters sided with leaving the EU, an outcome at odds with what bookkeepers were projecting.

Convertibles:

The sessions following the Brexit vote provided the latest acid test for convertibles, and they passed. In the trading day following the vote, U.S. convertibles lost only -2.15% versus -3.59% for the S&P 500 (see Figure 1). By the end of the next session, convertibles troughed at a loss of -3.66% versus -5.34% for the S&P 500. By July 8th, only 9 days after the recovery began, both stocks and convertibles surpassed their June 23 closing levels finishing 18 basis points higher than the S&P - or 2.12% versus 1.94% - when compared to their pre-Brexit level. Two trading days later, the S&P 500 reached all time highs, and convertibles had held their own, finishing 18 basis points higher than the S&P or 2.12% versus 1.94% for stocks when compared to their pre-Brexit level..

Source: Bloomberg LLP, 07/14/16. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index. BofA Merrill Lynch All Convertible Bonds 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 Standard & Poor's 500 Index (S&P 500) is an index of 500 stocks chosen for market size, liquidity and industry grouping, among other factors. The S&P 500 is designed to be a leading indicator of U.S. equities and is meant to reflect the risk/return characteristics of the large cap universe. The Russell 2000 index is an index measuring the performance approximately 2,000 small-cap companies in the Russell 3000 Index, which is made up of 3,000 of the biggest U.S. stocks. The Russell 2000 serves as a benchmark for small-cap stocks in the United States.

Ed was not surprised that convertibles held up better under the pressure following the Brexit vote. Historically, convertibles have exhibited favorable upside/downside capture dynamics relative to large cap US stocks, and this was not the first time he’s seen financial markets become unglued in response to surprising news (figure 2).

Source: Morningstar, 3/2/16. Convertible securities represented by the BofA Merrill Lynch All U.S. Convertibles Index. U.S. large-cap stocks represented by the S&P 500 Index. Past performance is no guarantee of future results. It is not possible to invest directly in an index. The BofA Merrill Lynch All U.S. Convertibles 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 S&P 500 Index is an unmanaged index and is widely regarded as the standard for measuring large-cap U.S. stock market performance. An upside capture ratio over 100 indicates a fund has generally outperformed the benchmark during periods of positive returns for the benchmark. A downside capture ratio of less than 100 indicates that a fund has lost less than its benchmark in periods when the benchmark has been in the red.

Relative Valuation and the Economic Outlook

Ed and the team believe equities and equity-linked securities are attractively valued, compared to the low yields on offer on U.S. Treasury bonds and investment-grade debt. (Treasurys are backed by the full faith and credit of the U.S. government.) They feel the U.S. stock market is fully valued but should benefit as profit growth resumes, especially profit growth in the energy sector.

Although they are bottom up investors first and foremost, the team’s view points on the economy haven’t changed much since we met last month except they can imagine interest rates staying lower for longer. Economic growth is apt to continue at a slow pace in the U.S. and globally, with low inflation and accommodative monetary policies. Given these conditions, the team believes equities and equity-linked securities have the potential to perform reasonably well in the 12-18 months ahead. However, it is not an environment that encourages taking unnecessary risks.

Ed stressed the team’s long-term focus didn’t lead to a lot of trading in the days following the Brexit vote. But he did feel a sense of comfort due to the credit rating of their holdings. While popular indices also project a BB+ rating, that’s because only the rated securities are included in the average.

Oil prices have advanced significantly since earlier in the year, with Brent crude just below $50 a barrel, so at the margin, the team is identifying more opportunities in the energy sector than a few months ago. In addition to being overweight the energy sector against its peers and benchmark, the team is also overweight industrials. By contrast, the team is underweight financials, utilities, and real estate investment Trusts (REITs).

Following a period of robust U.S. convertible new issuance in 2013-2015, new issuance throttled back from an annual pace just over $50 billion to roughly half that amount. In all, the previous high-yield nature of the new issuance market of the past three years remains intact. Investment-grade issuers are expected to hold back, somewhat, as long as 10-year Treasury yields remain below 3.5% or so.

Conclusion

Slow economic growth, low inflation and attractive valuations provide an encouraging backdrop to an asset class that has little correlation to changing interest rates and less historical volatility than the equity market.

The opinions expressed are those of MacKay Shields LLC as of the date of this report and are subject to change. There is no guarantee that any forecast made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any specific investment.

1According to Lipper, the awards recognize funds for their consistently strong risk-adjusted performance relative to their peers, based on Lipper’s proprietary performance-based methodology. Those funds with the most consistent return within their classification were declared. The winner over three, five, or 10 years. MainStay Convertible Fund Class I shares received the Lipper Fund Award in the Convertible Securities Funds category for the three-year period annualized out of 71 eligible funds as of 11/30/15. For a detailed explanation, please review the Lipper Fund Awards Methodology document at www.lipperweb.com. From Thomson Reuters Lipper Awards,© 2016 Thomson Reuters. All rights reserved. Used by permission and protected by the Copyright Laws of the United States. The printing, copying, redistribution, or retransmission of this content without express written permission is prohibited. Award for U.S. region only.