Minimizing Downside Risk

The stock markets have continued to churn higher this year. Given today’s equity valuations, investors may want to consider convertibles as a way to maintain some equity exposure and help minimize downside participation in the event of a market correction.

Despite disappointment regarding the trajectory of some of President Trump’s growth initiatives, natural disasters, and geopolitical issues, 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 Fed is poised to further tighten monetary policy.

Upside Potential with Potentially Less Downside Risk

In this market environment, convertible securities may offer an attractive alternative for investors who are looking for an interest paying bond investment that allows them to participate in stock price appreciation with less downside risk and historically less volatility than equities. Convertibles also have a negative correlation to U.S. Treasury bonds. As such, they have historically performed well in rising rate environments.

Attractive Market Environment/Reduced Equity Sensitivity

Recent market developments have reinforced the attractiveness of convertibles: The market has seen strong new issuance volume—a trend we expect to continue. When new convertible issues come to the market, they are usually priced at par, and have a fair measure of equity sensitivity, but also offer a degree of downside protection. At the same time, a number of large equity-sensitive convertibles, which lack the traits of fixed income, were redeemed this year. Both developments have contributed to a reduced equity sensitivity of the overall market which is good news for investors looking for upside potential and downward protection.

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All data as of 31.12.2016. Source: BofA Merrill Lynch, used with permission. As measured by the Bank of America Merrill Lynch U.S. Convertible Bond Index