Investors who use asset allocation as a way to seek the highest risk-adjusted returns may be struggling with how to invest an equity or fixed-income allocation in today’s market. If that is the case, consider convertible securities, which offer the potential upside of equities with potentially less downside risk. Institutional investors have been diversifying their pension portfolios using this defensive, total return instrument for many years. Convertible bonds provide investors with the income stream of bonds as well as the growth potential of stocks. Historically, they have provided higher returns than bonds, albeit with greater risk given their equity attributes. Convertibles allow the potential to participate in the equity markets while giving bond-like defensive features in turbulent markets. We recently caught up with Edward Silverstein, CFA, Senior Managing Director, Head of Convertibles, to get his thoughts on allocating convertible bonds in institutional portfolios. He discussed the recent performance of convertible securities and shared client case studies on the benefits of the asset class.

Asymmetric Return Capture of Convertibles

The first half of 2019 is off to a strong start. Year-to-date through June 30, 2019, the broad convertible U.S. market is up 14.50% while the S&P 500 Index gained 18.54%. Year-to-date through April 30, 2019, the convertible U.S. market1 participated in 72% of the upside of the S&P 500 Index. At May 31, 2019, however, the S&P 500 Index was down more than 6% for the month, whereas convertibles1 were down 3% and picked up about 51% of the downside (Figure 1). Convertible bonds demonstrated their defensive characteristics, offering investors some measure of protection when compared to equities. Convertible bonds and equities moved lower in May largely due to investor fears that a trade war with China will impair commerce, and subsequently corporate profits. In addition to tariff fears, several data points caused concern that worldwide economic growth is cooling. German manufacturer data showed for the month of May a slowdown in Europe’s largest economy while home and auto sales in the U.S. weakened.

Although past performance is no guarantee of future results, during the past 17 years, convertible securities have provided returns comparable to U.S. large-cap stocks, on average, in rising equity markets but generally helped to protect principal when stocks were falling (Figure 2). Consequently, we believe an allocation to convertible securities may have helped reduce overall portfolio volatility without unduly depressing long-term return potential.

This defensive aspect of convertible securities can also be seen in their long-term risk/reward profile. During the period from January 1, 2002 to May 31, 2019, convertible securities posted competitive returns relative to U.S. large-cap stocks (Figure 2). Convertible securities have also historically outperformed corporate bonds and government bonds, but with a higher standard deviation (Figure 3).

Positive Supply/Demand Technicals

Also supporting the convertible market has been robust supply that has been well absorbed by investor demand. Issuance in 2018 was in excess of $50 billion, continuing a strong trend which began in 2013. The surge in new issuance was largely due to the simultaneous rise in stock prices and interest rates. With the rise in rates, issuing companies could once again realize a significant interest savings by issuing a convertible bond instead of a non-convertible high yield security. For most investment grade companies, however, rates remain so low in absolute terms that the benefits of a convertible offering remain relatively muted. As such, the preponderance of new issuance over the past five years has been from non-investment grade companies. Additionally, following the stock market decline of 2008, companies were reluctant to issue equity-linked securities as they believed that doing so would dilute existing equity holders at prices they believed undervalued their companies. However, with stocks at near-record levels, companies are no longer reluctant to issue a security linked to their equity.

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