Diversifying a Portfolio with Convertibles

With the possibility of being in the latter stage of the economic cycle, coupled with above average valuations, investors worried about an increase in volatility may be looking to lower their equity exposure and increase their allocation to bonds. At the same time, the prospect of rising interest rates has taken some of the luster out of the bond market. Against this backdrop, it may be prudent to consider diversifying a portfolio with convertible bonds. We recently checked in with Edward Silverstein, CFA, Senior Managing Director, Head of Convertibles, at MacKay Shields. He discussed the recent performance of convertible securities and MacKay Shields’ views on the asset class.


Convertibles 101

A convertible bond is a type of bond that the owner can convert into a specified number of shares of common stock in the issuing company. Generally speaking, convertible securities give investors the income stream of bonds, plus the growth potential of stocks, with historically less equity risk. With a convertible, a company can issue debt for less interest expense than straight debt, and investors receive that lower income in exchange for the potential to convert the bond into stock at a later date. If an investor does not convert the bond into stock, they still get their interest payment and principal at maturity.

Convertibles leading the way

Through the first five months of the year, convertibles have outperformed both the broad U.S. stock market and the overall bond market. This has been partially driven by the strong results from small- and mid-caps and from the information technology (IT) sector—the latter represents approximately a third of the total convertible market. We’ve seen the IT sector significantly outperform the S&P 500 Index, driven by overall strong earnings.

Source: NYLIM and Morningstar, as of 6/20/18. Past performance is no guarantee of future results. It is not possible to invest directly in an index.


Positive Supply/Demand Technicals

Also supporting the convertible market has been robust supply that has been well absorbed by investor demand. Through the end of May, there has been $27 billion of new convertible issuance, which we believe would put us on track for $55 to $60 billion in 2018 as a whole. This is a significant amount given that the size of the overall convertible market is roughly $190 billion. It’s important to have a healthy amount of new issuance, as convertible bonds regularly mature or are called away.

Fair Valuations

While valuations in certain segments of the equity market are rich from a historical perspective, we view convertibles to be fairly valued. And, we expect this to remain the case as the year progresses given strong investor demand. Convertible valuations are calculated by the sum of its two parts: the present value of the cash stream of the bond and the value of the imbedded call option. Combining these numbers gives you the theoretical value of an individual bond. The BofA Merrill Lynch All U.S. Convertibles Index is currently trading right around fair value, versus being about 1% overvalued earlier in the year. For comparison purposes, the convertible market has historically traded at a 1½% discount to fair value*.

*Source: BofA Merrill Lynch which provides monthly data on the relative cheapness and richness of convertible securities versus their theoretical value. Historically convertibles have traded at about a 150 basis point discount to their theoretical value.

Low Correlation to the Bond Market

While they are technically bonds, over time convertibles tend to perform more like stocks than bonds. This is demonstrated in the table below that shows the correlations between convertibles, stocks, and bonds. This is an important consideration for investors who are concerned about the negative impact on their bond holdings should interest rates continue to move higher.

Source: Morningstar, 1/1/98 – 12/31/17. Convertible securities are represented by the ICE Bank of America Merrill Lynch U.S. Convertible Index; U.S. large-capitalization stocks are represented by the S&P 500® Index; U.S. mid-capitalization stocks are represented by the Russell Midcap® Index; U.S. small-capitalization stocks are represented by Russell 2000® Index; Treasury bonds are represented by the ICE BofAML U.S. Treasury Master Index; U.S. corporate bonds are represented by the ICE BofAML U.S. Corporate Master Index; Treasury bills represented by the ICE BofAML US 3-Month Treasury Bill Index; International stocks represented by the Morgan Stanley Capital International (MSCI) Europe, Australasia, and Far East the (EAFE) Index. Index definitions can be found at the end of this article.


Credit Analysis and Fundamental Research Is Critical

The overall U.S. convertible bond market represents more than 400 issues. However, it’s important to note that around half of these securities are not rated. As such, it can be difficult for individual investors to accurately determine the creditworthiness of these issuers. In our view, this demonstrates the importance of investing in convertibles with a professional manager that has the resources to thoroughly analyze individual securities. In particular, we believe it’s critical to have a clear understanding of an issuer’s underlying fundamentals, including its free cash flow, leverage and future business prospects.

Conclusions

The convertible bond market has generated strong results this year and demand for the asset class has been robust. We believe convertibles represent an attractive opportunity for investors to diversify their portfolio and participate in the potential upside of the stock market, with less downside risk. In addition, convertibles tend to perform relatively well in rising interest rate environments.



Definitions

BofA Merrill Lynch All U.S. Convertibles Index – The 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 Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based benchmark that measures the investment-grade, U.S. dollar-denominated, fixed-rate taxable bond market, including Treasuries, government-related and corporate securities, mortgage-backed securities (agency fixed-rate and hybrid adjustable-rate mortgage pass-throughs), asset-backed securities, and commercial mortgage-backed securities.

An embedded option is a special condition attached to a security and, in particular, a bond, that gives the holder or the issuer the right to perform a specified action at some point in the future. An embedded option is an inseparable part of another security, and as such does not trade by itself. Nevertheless, it can affect the value of the security of which it is a component.

ICE BofAML U.S. Convertible Index – an unmanaged market capitalization-weighted index of domestic corporate convertible securities that are convertible to common stock only.

ICE BofAML U.S. Corporate Master Index tracks the performance of investment grade corporate debt publicly issued in the U.S. Qualifying securities must have at least one year remaining term to final maturity, a fixed coupon schedule and a minimum amount outstanding of $250 million.

ICE BofAML U.S. 3-Month Treasury Bill Index is comprised of a single issue purchased at the beginning of the month and held for a full month. At the end of the month that issue is sold and rolled into a newly selected issue.

ICE BofAML U.S. Treasury Master Index tracks the performance of sovereign debt publicly issued by the U.S. government in its domestic market. Qualifying securities must have at least one year remaining term to final maturity, a fixed coupon schedule and a minimum amount outstanding of $1 billion.

Morgan Stanley Capital International (MSCI) Europe, Australasia, and Far East the (EAFE) Index – an unmanaged, capitalization-weighted index containing approximately 985 equity securities of companies located outside the United States

Russell Midcap® Index – an unmanaged index that measures the performance of the 800 smallest companies in the Russell 1000® Index.

Russell 2000® Index – an unmanaged index that measures the performance of the 2,000 smallest companies in the Russell 3000® Index.

The S&P 500 Index is widely regarded as the best single gauge of large-cap US equities. The index includes 500 leading companies and captures approximately 80% coverage of available market capitalization.