Looking Under the Hood of Convertibles' Strong Returns

The stock market reached a new all-time high at the end of the third quarter. With the bull market now at 8+ years—the second longest on record—investors may be looking to take some chips off the table. At the same time, the bond market could be vulnerable as the Federal Reserve (the Fed) is poised to further tighten monetary policy. So, where can investors turn? We recently checked in with Edward Silverstein, CFA, Senior Managing Director, Head of Convertibles, at MacKay Shields.

How High Can It Go?

The stock market’s resilience this year continues to surprise many financial pundits. Despite disappointment regarding the trajectory of some of President Trump’s growth initiatives, natural disasters, and geopolitical issues, the market continues to churn higher. Investors who fled risk assets, fearing an end to the lengthy bull market, have missed out on some heady gains. Still, it may be prudent to hedge one’s bets. And, convertible bonds could be the answer.

Convertibles 101: Hitting the “Sweet Spot”

A convertible is a hybrid security that includes the features of both stocks and bonds in a single investment. Convertible securities provide investors with the income stream of bonds, plus the growth potential of stocks. A type of bond issued by a company, a convertible security can be converted into a predetermined number of shares of common stock. Given today’s equity valuations, convertibles are a way to maintain some equity exposure and help minimize some downside participation in the event of a market correction.

Riding the Wave

While convertible securities are a more conservative investment than pure equity exposure, they’ve posted strong results thus far in 2017. Through the first nine months of the year, convertibles, as measured by the Bank of America Merrill Lynch U.S. Convertible Bond Index, have gained 11.96%, versus a 14.24% return for the S&P 500 Index. Meanwhile, the bond market, as measured by the Bloomberg Barclays U.S. Aggregate Bond Index, is up a mere 3.14%.

Source: Morningstar Direct, as of 9/30/17. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.

Looking Under the Hood

By taking a closer look at the convertible market, we can see that a portion of its ascent has been driven by its exposure to technology. At a 35% weighting, technology remains the largest sector in the convertible market. But, unlike the concentration of the “FAANG” (Facebook, Apple, Amazon, Netflix, and Alphabet’s Google), convertible issuance from technology companies is diversified among a large swath of industries, including hardware, software, internet-related, and peripherals, to name a few.

Avoiding the Headwinds

At the other end of the spectrum, the convertible market has relatively low exposure to two areas of the market that have underperformed this year: retail and energy. The “Amazon effect” continues to pressure traditional brick-and-mortar retail companies. Yet, retail is less than 2% of the convertibles index. Until recently, energy has been one of the stock market’s laggards. But, at less than a 6% weighting, energy hasn’t had a large impact on the convertible market.

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This material contains the opinions of the MacKay Convertibles Bond Team of MacKay Shields LLC, but not necessarily those of MacKay Shields LLC. The opinions expressed herein are subject to change without notice. This material is distributed forinformational purposes only, and is not intended to constitute the giving of advice or the making of a recommendation. The investments or strategies presented are not appropriate for every investor, and do not take into account the investment objectives or financial needs of particular investors. An investor should review with its financial advisors the terms and conditions and risks involved with specific products or services, and consider this information in the context of its personal risk tolerance and investment goals. Forecasts, estimates, and certain information contained herein are based upon proprietary research, and should not be considered as investment advice or a recommendation of any particular security, strategy, or investment product. Any forward looking statements speak only as of the date they are made, and MacKay Shields LLC assumes no duty and does not undertake to update forward looking statements. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of MacKay Shields LLC.

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