Convertible bonds have, historically, been regarded as an asset class capable of combining the desirable attributes of both fixed-income securities and equities. Although that reputation has been challenged in recent years due to some uncharacteristic performance, convertible investment strategies have evolved to the point where they may again provide the income and relative stability of bonds and the potential capital appreciation of equities. (See Chart 1 for the traditional return profile of a convertible bond.)

These hybrid characteristics of convertibles may be of particular interest to those investors who have concerns about how their fixed-income holdings may fare if interest rates were to rise from their historically low levels.

A Consistent Track Record
Rising interest rates generally indicate improving economic conditions, and equity prices often appreciate as a result. And due to convertible bonds' potential conversion into an issuer's equity, this asset class, historically, also has appreciated in most cases when the 10-year Treasury yield has risen by 100 basis points (bps) or more. (See Table 1.)

Accordingly, the performance of the convertible bond market historically has been less correlated with interest-rate movements during times of interest-rate volatility. Therefore, adding convertibles to a portfolio of traditional corporate debt may add a higher level of participation in stock movements, while potentially lowering a portfolio's interest-rate sensitivity.

Indeed, the traditional return profile of convertible securities indicates they might capture approximately 70% of an upswing in the underlying equities, while they might participate in only about 40% of a decline in the underlying equities. Although convertibles may not perform in a similar manner in the future, the traditional return profile suggests that when adding convertibles to a stock portfolio, the potential reduction in volatility could more than offset the reduction in returns.

The trade-off for convertible bonds' historical participation in equity gains generally has been that they have provided lower yields compared to the broader fixed-income market. But in a post–2008 environment where the yields in many fixed-income categories have reached 50-year lows, the yield in the convertibles market generally has remained steady at 3.3% as of the end of 2012. Some changes in the convertible market's composition contributed to this relative yield stability, which could appear attractive versus yields in the U.S. Treasury and corporate debt markets. (See Chart 2.)

Some Anomalous Stints
In addition to periods of rising interest rates, longer return periods also demonstrate how convertible bonds have participated in a significant portion of the equity market's returns.

On a three-year basis, for example, convertible securities delivered about three-quarters of the total return on the S&P 500, Nasdaq Composite,⁶ and Russell 1000⁷ indexes, as of December 31, 2012. Moving to five-year returns, the convertibles market posted a total return that outperformed all of those equity indexes, while also outperforming the S&P 500 on a 10-year basis. Over 10 years, the convertibles market returned 97% and 86% of the Russell 1000 and Nasdaq Composite's total return, respectively. (See Chart 3.)

Convertible bonds, however, have not always provided the downside protection that investors traditionally expect, as observed by their performance in two recent years. The first was during the financial crisis of 2008, when the S&P 500 declined by 37% and the convertibles market staged a similar retreat of 35.7%. At that time, financial issues comprised more than 20% of the overall convertibles market and an even higher portion, more than 40%, of the investment-grade convertibles market.⁸

This concentration developed after many large financial institutions issued convertible preferred securities to enhance their capital levels. And as the financial crisis accelerated, these institutions were considered to be susceptible to further contagion. As a result, major issuers, such as AIG, Bank of America, Lehman Brothers, and Wachovia, sustained significant declines in equity values. This performance, coupled with the widespread increases in corporate bond spreads relative to Treasury yields, produced the poor convertible returns experienced in 2008.

In addition, there was an unprecedented, temporary ban on short sales of financial stocks during the height of the financial crisis. This ban actually exacerbated the situation as converti-ble arbitrageurs⁹ were unable to hedge their positions, which heightened the illiquidity and volatility in the market.

After 2008's difficult market conditions, however, convertibles went on to outperform the S&P 500 by a wide margin in 2009.

The second period of underperformance was in 2011, when convertibles posted a negative return of more than 5%, while the S&P 500 achieved a positive total return of 2.1%, according to Bloomberg. Yet this performance warrants closer examination, because convertible bonds actually held up as expected relative to their underlying stocks. Due to extreme moves in biotech, solar, and some financial stocks, the equities underlying the convertible market were down by more than 13% during 2011. This performance dynamic was also reflected by the S&P 500's outperformance of many smaller-cap indexes in 2011.

Given the unique set of circumstances that contributed to these two periods, they could be regarded as outliers in an otherwise consistent history of performance. After all, the financial sector currently represents a smaller portion of the overall market, and investors, such as hedge funds, that were focused on arbitrage opportunities have less market influence, while traditional long-only investors have come to dominate trading flow.

Change in Composition
The reduced representation of the financial sector is not the only compositional change to have taken place in the market since 2008. And these changes are a function of perhaps the largest influence on the capital markets, which has been the unprecedented easing of monetary policy and the consequent environment of historically low interest rates.

Given the ample fixed-income demand and record-low cost of bond financing—combined with what many managers consider to be undervalued equity—corporations have been less willing to issue potentially dilutive convertible bonds. For example, an industrial issuer with an 'A' credit rating could recently issue a five-year corporate bond at a spread of 100 bps over Treasuries, or about 1.75%, according to Bloomberg. And the effective aftertax cost of that capital issuance is closer to 1%.

As a result, the size of the convertibles market ended 2012 at $194 billion, and comprised 468 issues, versus $313 billion and 746 issues just five years ago, as measured by BofA Merrill Lynch. Another important trend has been the shift from being a largely investment-grade market to one with a greater component of below-investment-grade and nonrated bonds. Indeed, the BofA Merrill Lynch All Convertibles Index was approximately 28% investment-grade rated as of December 31, 2012, nearly half of what it was a decade earlier. (See Chart 4.)

The recent lack of issuance, however, appears to be a cyclical issue driven by the low-rate environment, and it is anticipated that more issuers will return to the asset class once rates begin moving higher. It also is encouraging that the convertible bond market recently has seen some debut entrants to the asset class. In 2012, for example, the market welcomed a total of $1.6 billion in new securities from diversified manufacturer United Technologies and consumer goods firm Jarden Corp. These transactions contributed to the $21.1 billion in total new issuance in 2012, according to BofA Merrill Lynch. And the year ended with some momentum, as the issuance in the fourth quarter was one of the strongest quarters in two years.

Widening the Opportunity Set
While the recent market contraction is considered to be a cyclical function of low interest rates, convertible strategies can augment their investment options by pairing traditional bonds and equity positions from the same issuer. These combinations are designed to replicate the upside/downside capture characteristics of traditional convertible bonds.

For example, a structured convertible position could consist of a weighting of 75% common stock and 25% debt. This approach is flexible, however, and could be adjusted to a mix of 60% equity/40% bonds or a 50%/50% combination based on a portfolio manager's opinion of market conditions.

Combining a partial position of common equity with a partial position of a straight bond could sacrifice some of the benefits of the convertible optionality, which can be responsible for a portion of a convertible security's potential return. However, the stock/bond combination could have major offsetting advantages. These include: 1) significantly augmenting the size and diversification of the investible universe; 2) increasing portfolio flexibility; 3) using the bond portions to enhance the overall credit quality and yield characteristics of the accounts; and 4) leveraging the best investment ideas from equity and fixed-income research departments.

Conclusion
In the current environment of historical monetary policy accommodation, there may be mounting concerns about the risks from rising interest rates. And although the convertible bond market may not perform in a similar manner in the future, convertible bonds have, historically, provided an effective hedge against rising rates when compared with other fixed-income instruments.

When rates do begin to rise, more issuers are expected to return to the asset class, underscoring that the lack of new convertible bond issues appears to be more of a cyclical, rather than secular, change. Meanwhile, combinations of equity and bond positions may replicate the upside/downside capture profile of traditional convertible bonds. This strategy also can help augment the investible universe of convertible securities while increasing portfolio flexibility and leveraging the top investment ideas from equity and credit research departments.

Contributors to this article: Alan Kurtz, Associate Portfolio Manager of Bond Debenture and Convertible Securities; LeAnne Schweitzer, Convertible Trader/Associate Portfolio Manager of Convertible Securities; and Andrew Dhanraj, Portfolio Analyst.