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Fixed-Income Insights

Amid concerns about rising interest rates and extended stock-market valuations, investors may wish to consider an asset class that historically has delivered equity-like returns with less volatility.

Auto enthusiasts know that you get the best of both worlds with a convertible. Flip the top down and enjoy a beautiful day; push a button and you are well protected when the weather turns inclement.  

You could make a similar statement about the convertible bond market. Over the years, it has allowed investors to participate in the upside of equity rallies, while also providing downside protection when the markets become more volatile.  In the current environment, it also offers a more attractive income stream than the equity markets.

In this report, we will give a quick review of the convertible bond market, drill down on its component sectors, and summarize our view of the merits of investing in the asset class.  We believe that now is a fortuitous moment to revisit the convertible bond market, as we encounter clients who are concerned by both the prospect of a further increase in interest rates and equity market valuations that are becoming increasingly stretched.

Convertibles 101
In the context of the global financial markets, convertible bonds are a relatively small asset class. Based on BofA Merrill Lynch index data (as of March 15, 2017), the global convertible benchmark index (represented by the BofA Merrill Lynch Global Convertible Index) had a market cap of $346 billion, with the U.S. benchmark (represented by the BofA Merrill Lynch Global Convertible Index) sized at $183 billion. Thus, many investors may not be familiar with the asset class, so a quick review might be helpful.  In short, a convertible bond is a corporate bond (with a coupon and fixed maturity date) that may convert into common stock of the issuing company at some point in the future. This, of course, assumes that the bondholder elects to convert his or her security into equity, rather than cash. The number of shares each bond can convert into and the conversion price are set at the time of issuance. 

Companies tend to issue convertibles for a few reasons. First, since convertibles may be providing the investor with an ownership stake in the future, the bonds often will carry a lower coupon than a traditional corporate debt issue. The convertible bond market also may afford market access to issuers during periods of stress, when it may be difficult to access the conventional corporate debt market. It also allows a company to set a higher price to issue equity at some point in the future. 

Issuers also may come to market with a convertible preferred structure if they are engaged in a significant transaction, such as an acquisition of another company. The convertible preferred issue has slight differences compared to a convertible bond (i.e., for common stock) transaction, but most important for the issuer, these securities often are accounted for as equity on the company’s balance sheet instead of debt. This allows the company to maintain a higher credit rating than if it had financed the transaction exclusively with debt.

Last, convertible bonds can be favorable to an issuer from a tax perspective. Under the current U.S. tax code, interest payments on debt typically are tax deductible, whereas dividends come from aftertax profit,1 so from a tax perspective, convertible debt securities are preferable to issuing equity.

Given the historically low interest rates we have seen in the aftermath of the 2008–09 financial crisis, convertible debt issuance over the last few years has come nowhere near the pre-crisis highs of 2001 or even 2007. (See Chart 1.) Issuers were easily able to tap the markets and pay microscopic coupons of 1–2% without having to give up a piece of the company. With interest rates forecast to push higher in 2017 and the years to come, we would expect to see convertible issuance increase.

 

Chart 1. U.S. Convertible Bond Issuance Remains Well Below Pre-Financial Crisis Levels
Annual issuance ($ in millions), 1998–2016 

Source: BofA Merrill Lynch Global Research.
Past performance is no guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.

 

Return Profile/Investment Case
Now that we have the review out of the way, we can approach the key question: What’s in it for an investor to own convertibles? In short, over the past 15 years, you would have received returns very close to those of the S&P 500® Index—with about 80% of the volatility. (See Chart 2.) In addition, during periods of volatility, the convertible bond market has experienced much smaller drawdowns than the underlying equities of issuers in the market. (See Chart 3.)  As you can see in the quarterly return data in Chart 3, convertibles may not have captured all the upside in rallying equity markets, but they have mitigated the losses to the downside.   In fact, over the last five years, convertible bonds have captured 70% of the upside and only 43% of the downside of the underlying equities.  For investors, this historical performance underscores the “best of both worlds” aspect of convertibles we spoke of above.  The convertibles index—which has a yield of 3.11%, as of February 28—also provides a more attractive income stream than the underlying equities (1.45%) and the S&P 500 (2.06%).

 

Chart 2. Convertible Bonds Historically Have Delivered Equity-Like Returns with Less Volatility
Quarterly returns and standard deviation of quarterly returns, January 2002–December 2016

Source: Morningstar. “BofA Merrill Lynch U.S. Convertible Index – Equity” represents the performance of the underlying equities of convertible bond issuers in the straight BofA Merrill Lynch U.S. Convertible Index.
Past performance is no guarantee of future results. 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.

 

Chart 3. How Have Convertibles’ Returns Stacked Up Against Their Underlying Equities?
Quarterly returns for the BofA Merrill Lynch U.S. Convertible Index and underlying equities of index issuers, first quarter 2012–fourth quarter 2016 

Source: Morningstar. “Convertible Total Return” represents the performance of the BofA Merrill Lynch U.S. Convertible Index. “Equity Total Return” represents the performance of the underlying equities of convertible bond issuers in the BofA Merrill Lynch U.S. Convertible Index.
Past performance is no guarantee of future results. 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.

 

How does this happen? First, there is a “bond floor” that will support the valuation of a convertible issue if the price of the equity deteriorates significantly. At the end of the day, a convertible note is still a bond with a coupon and set maturity date, so as the stock moves out of the money, investors will start to evaluate the instrument based upon its underlying credit fundamentals. Within a convertible bond, there is an “option” to convert that bond into equity at a predetermined price and date. When the volatility of a stock increases, that option becomes more valuable. In a declining market, the option becomes further “out of the money,” but the volatility increases the value of the option, which offsets some of the decline in the convertible bond relative to the underlying equity.

Under the Hood
Another question an investor may ask is, what am I buying when I invest in convertible bonds? Since convertibles are not on the radar for many investors, it might help to take a closer look at the composition of the market. (See Chart 4.) On a market-value basis, a little more than one-third of the U.S. convertible bond market falls within the technology sector. Within the tech sector, meaningful subsectors include software/services, equipment manufacturers, and network service providers. Health care and financials are the two other most meaningful sectors, each accounting for a bit more than 15% of the market.  

 

Chart 4. Technology, Financials, and Health Care Have Dominated the U.S. Convertibles Market
Sector breakdown by market value of the BofA Merrill Lynch U.S. Convertible Index, as of January 31, 2017

Source: BofA Merrill Lynch Global Research.
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.

 

Health care and technology have always represented significant portions of the convertible bond market for a few reasons. First, these are two sectors of the economy that have seen constant growth, innovation, and the creation of new companies in recent years. These newer companies often may not yet be ready for financing via the leveraged loan or high-yield markets, but they may follow up an initial public offering with a convertible debt issue a few months afterward. The growth and risk profiles for many of these issuers do make them much better candidates for equity-like investments than credit.  

While financials are a meaningful portion of the index on a market-value basis, they do not provide much equity sensitivity. Most of these instruments are bank convertible preferred securities that were issued prior to the financial crisis, with the current equity price way out of the money relative to the conversion price at the time of issuance.

When we examine the underlying issuers by market cap, we find that about 60% of the market is large-cap issuers and 30% mid cap, with small caps sitting at just less than 10%. These weightings have been relatively consistent over the last several years. 

Hitting the Road
We hope we have provided enough evidence to convince you of the merits of considering allocating a portion of your portfolio to the convertible bond market. In an environment where many investors are grudgingly buying into a rising equity market, despite concerns about valuations, the return profile of the convertible bond market, we believe, warrants consideration. It’s quite surprising to us, however, that convertibles are so underrepresented in client portfolios, considering the fact that the market has been in existence for more than 100 years. In the late 1800s, for example, convertibles helped finance the expansion of railroads, a key cog in the development of the modern U.S. economy.  

Fortunately, we at Lord Abbett have been investing in the convertible bond market for almost 50 years as part of our history with leveraged credit. This experience and our well-resourced team of investment professionals allow us, we believe, to continue capitalizing on the opportunities that the convertible bond market potentially can offer in the months and years to come. We believe that investors searching for an asset class that historically has delivered equity-like returns with reduced risk potential may find convertibles a vehicle worth considering.

 

1”Overview of the Tax Treatment of Corporate Debt and Equity,” U.S. Senate Committee on Finance, May 24, 2016.

 

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The Lord Abbett Convertible Fund seeks to deliver current income and the opportunity for capital appreciation by investing in convertible securities.

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