Why we believe in convertible bonds for 2019
A convertible bond is a fixed-rate instrument that can convert into shares at a specific share price, which is preset by the issuing company at a premium over the current share price. The bond also has a coupon, but the interest rate is lower than a normal bond's, because the conversion feature gives it an equity upside.
Convertibles therefore have an equity correlation and can move with the underlying share price, but also have a ‘bond floor’ – i.e. a price below which they cannot fall (unless the company loses creditworthiness) due to the interest rate they are paying. This hybrid bond-equity make-up can shape convertibles into a flexible and attractive vehicle, providing excellent investor opportunities. It optimally protects an investor’s initial investment on the downside but also lets them make the most of the upside as the company’s shares increase in value.
Introducing different varieties of convertible
- Some operate way below the share price at which the bond converts and will behave like regular bonds, as the equity kicker is too far away to matter
- Some have become pure equity, as the share price has risen substantially
- Others are in between and trade with a mixture of both the bond and equity factors, known as the ‘balanced’ zone.
The graph below shows how this works.
What kind of returns do convertible bonds offer?
Historically, convertible bonds have returned as much as equities, but with about half the volatility. If that sounds too good to be true, there are a couple of caveats:
1. Interest rates and bond yields have dropped for decades, helping bond floors go up
2. The convertible market is much smaller than the equity markets, so you could never replace all the shares in your portfolios with convertibles.
However, when interest rates rise and equities feel nervous about how far rates will go, convertibles have often delivered a better risk/return ratio than a simple blend of equities and fixed income. That's why we believe they are a key investment theme for 2019.
Good convertible managers move from one bond to another and take advantage of market moves. The same managers can also move from one region of the world to another, or one credit rating to another, and hedge or not hedge the underlying currency of the bond. This creates a lot of variables for an active manager to play with.
An important investment theme for 2019
Properly managed, convertibles can give a great risk/return ratio and improve that ratio in a diversified portfolio, making them a valuable addition while equity markets continue to climb an ever-growing wall of worry. They are certainly an important theme that will be playing out in our client portfolios in 2019.
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IMPORTANT: Investment involves risk. The value of investments and the income from them can go down as well as up and you may not get back the amount originally invested. Past performance is not a reliable indicator of future performance.