Convertibles: A Lower Volatility Approach to Equity Investing | Lord Abbett
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Equity Perspectives

Convertible securities historically have delivered an attractive return profile and lower volatility compared with traditional equities.

 

In Brief

  • Investors may have concerns about potential future equity returns, with the current bull market now the longest-running in U.S. history and major stock indexes recently reaching new all-time highs.
  • Instead of shying away from equities, we believe some investors should consider convertible securities (convertibles), which have historically delivered an attractive return profile and lower volatility compared with traditional equities.
  • We think now is a particularly opportune time to consider convertibles, with the asset class displaying a more balanced exposure to underlying equities than in recent history.

With 2019 coming to a close and U.S. equity markets delivering healthy double-digit gains, based on Bloomberg data, some investors may be reassessing their exposure to stocks as they turn their attention to the New Year. The current bull market encompassing the past decade is now the longest one in history, and major U.S. stock indexes are near all-time highs. Wariness towards equities is evident in the $40.9 billion of net asset flows out of U.S. equity mutual funds during 2019 even as the market has climbed higher (see Chart 1).

 

Chart 1. During a Strong Year for Stocks, Investors Have Pulled Money from U.S. Equity Mutual Funds
Cumulative asset flows into indicated U.S. mutual fund categories, January 9, 2019–November 13, 2019

Source: Simfund. Data as of November 13, 2019.
For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
Past performance is not a reliable indicator or guarantee of future results.
 

We believe that investors who are concerned about future equity returns should consider convertible securities (convertibles) as an alternative strategy to gain exposure to equities. The U.S. convertibles market offers certain characteristics that may be attractive to some investors in the current environment:

1. Equity-Like Returns with Reduced Volatility: The Bloomberg Barclays U.S. Convertibles Index (Convertibles Index) has averaged annualized gains of 7.0% over the past five years, while maintaining a low 8.9% annualized standard deviation of these returns. These represent competitive historical returns to equities, but with far lower volatility (see Chart 2).
 

Chart 2. Convertible Bonds Have Provided Attractive Returns with Less Volatility Than Conventional Equities
Return and standard deviation for indicated indexes, September 30, 2014–September 30, 2019

Source: Bloomberg Barclays Indices. Data as of September 30, 2019.
For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
Past performance is not a reliable indicator or guarantee of future results.

 

Convertibles’ lower historical volatility was evident during the rocky fourth quarter of 2018, when equity markets were down sharply. From the end of September through December 24, 2018, the S&P 500 Index declined 18.9%, the Nasdaq Composite Index was down 22.8%, and the Russell 2000 Index dropped 25.1%. The Convertibles Index, however, was only down 12.4% (see Chart 3).

 

Chart 3. Convertibles Fared Better than Equities during a Rough Final Quarter of 2018
Total return for indicated indexes, September 28, 2018–December 24, 2018

Source: Bloomberg. Data as of December 31, 2018.
For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
Past performance is not a reliable indicator or guarantee of future results.

 

2. Asymmetric Return Profile: A convertible bond provides the downside support of a fixed income instrument while also carrying the potential for price appreciation alongside the underlying equity. This non-linear, asymmetric return profile that has historically maximized upside potential while limiting downside risk is known as convexity and is a unique attribute of convertibles investing. Over the past five years, the Convertibles Index has captured 74% of the upside of their underlying equities, while only realizing 33% of the downside (See Chart 4).

 

Chart 4. Convertibles Historically Have Provided Potential for Price Appreciation with Less Downside Risk than Underlying Equities
Monthly total returns for indicated categories, September 30, 2014–September 30, 2019

Source: Bloomberg Barclays U.S. Convertibles Index monthly return data (as of September 30, 2019). This calculation excludes those months where underlying equity returns were between -0.5% and 0.5%.
For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Dividends are not guaranteed and may be increased, decreased, or suspended altogether at the discretion of the issuing company.
Past performance is not a reliable indicator or guarantee of future results.

 

3. Income: Convertibles’ coupons provide an income component to returns that is usually greater than what can be found in the issuers’ underlying equities. According to data from Bloomberg, as of November 15, 2019, the Convertibles Index offered a yield of 2.5%, comparing favorably to the dividend yields on the S&P 500 (1.9%), Nasdaq (1.1%) and Russell 2000 (1.7%) indexes.

While these three elements are attractive features of convertibles investing in general, we think the current market environment is an especially favorable time to give convertibles a look. The delta of the U.S. convertibles market, which measures the convertibles’ equity sensitivity to their underlying stocks, has fallen to multi-year lows in 2019, as more seasoned in-the money, equity-like securities have matured. Corresponding to this reduction in delta has been a similar decrease in the market’s investment value premium, a sign of greater downside protection compared to recent history (see Chart 5). Collectively, these market characteristics are indicative of a more balanced convertibles market, one which provides exposure to potential price appreciation through the outperformance of the underlying stocks, but which also presents the possibility of more ample downside support in the event equities decline.

Chart 5. Reduced Delta, Investment Premium Signal a More Balanced Convertibles Market in 2019
Delta (equity sensitivity to underlying stocks) and investment value premium for the Bloomberg Barclays U.S. Convertibles Index, September 30, 2014–September 30, 2019

Source: Bloomberg Barclays Indices. Data as of September 30, 2019.
For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Dividends are not guaranteed and may be increased, decreased, or suspended altogether at the discretion of the issuing company.
Past performance is not a reliable indicator or guarantee of future results.

 

Summing Up
For investors seeking equity exposure but who may be worried about future returns, a look at convertibles may be in order. Convertibles’ convexity offers an asymmetric return profile that has historically delivered attractive returns with lower volatility as compared to U.S. equities. And while the U.S. equities market is near all-time highs, the convertibles market has become more defensively postured over the past year, which in our view, provides a favorable backdrop for investing in the asset class. Specifically, investors may wish to consider an actively managed strategy in this space. The unique structure of convertibles may result in misvaluations in the equity, fixed income, or option components of these securities, creating opportunities for experienced professional investors.

 

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