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Market View

Investors looking for income plus equity-like returns, but with lower volatility, may be surprised at the unique return profile and diversification benefits of convertibles. 

Investors face a number of challenges and trade-offs when constructing a portfolio to meet their long-term goals. Many are looking for income, but are struggling to find it in the current low-yield environment. At the same time, they fear the impact that rising rates may have on their fixed-income portfolios. Others need long-term growth that the equity market historically has provided, yet are concerned about potential volatility and are hesitant to increase risk in order to reach their return targets.

To address some of the challenges of today’s market, convertible bonds may merit closer inspection.  As we previously indicated, convertibles are a relatively small asset class.  Since they do not fit neatly into any one “style box,” many investors are unsure how convertibles may fit into a portfolio.

A Brief Review
In short, a convertible bond is a corporate bond (with a coupon and fixed-maturity date) with an option that allows the holder to convert the bond into the common stock of the issuing company at some point in the future. The number of shares into which each bond can be converted and the conversion price are set at the time of issuance. While there are many different types of convertible bond structures, they generally exhibit characteristics of both equity and fixed-income securities. Depending on valuations and market conditions, a convertible may act more like a stock or more like a bond at any given time.    

Since convertibles can be exchanged for equity, they offer the potential to participate in the upside of a rising equity. However, if the underlying equity does not increase in value, the convertible still maintains the investment value of the “bond floor,” or the value at which a straight bond of the same coupon, maturity, and credit quality would trade. This unique structure—which allows potentially for participation in a rising equity market, but protection when equity markets are declining—has led to attractive risk-adjusted returns over the long term.

Benefits to Investors
Here are a few reasons to consider an allocation to convertible bonds:

1. Income—On April 30, 2017, the U.S. convertible bond market (as represented by the BofA Merrill Lynch U.S. Convertible Index) offered a yield of 3.0%—a 50% yield advantage over the dividend yield of the S&P 500® Index—making convertibles an attractive alternative for investors looking for income through dividend-paying stocks.

2. Equity-like returns, with lower volatility—Over the long term, U.S. convertible bonds have generated similar returns to the U.S. equity market, but have done so with lower volatility, resulting in higher risk-adjusted returns (as measured by the Sharpe ratio) over the trailing 10-, 15-, and 20-year periods.  In fact, as illustrated in Chart 1, over the 20-year period ended April 30, 2017, the convertible index has generated slightly higher returns than the S&P 500, but with 15% lower volatility.  This risk-return profile should make convertibles attractive to investors who need the growth potential of the equity market, but want to reduce their exposure to equity market volatility.

 

Chart 1. Convertible Bonds Historically Have Offered Equity-Like Returns with Lower Volatility
(05/01/1997 – 04/30/2017)

Source: Zephyr. *As represented by the BofA Merrill Lynch U.S. Convertibles Index. **As represented by the S&P 500 Index.
The historical data shown are for illustrative purposes only and do not represent any specific portfolio managed by Lord Abbett or any particular investment.

 

3. Performance during periods of rising rates—Income investors traditionally have looked to the bond market, but the potential for a rising-rate environment and the risks that such an environment may pose to a bond portfolio has kept many bond buyers on edge. But as we have pointed out before, there are many parts of the bond market that historically have fared well in the face of rising U.S. Treasury rates, namely short-term corporate bonds, floating-rate bank loans, and high-yield bondsEquity-related securities such as U.S. convertible bonds also have fared well, generating positive returns in seven of the past eight periods that 10-year Treasury yields rose by 100 basis points or more, as illustrated in Table 1.  In fact, a review of the average returns over these eight periods will indicate that convertibles had the highest average return of any of the asset classes listed here.

 

Table 1. U.S. Convertible Bonds Have Offered Strong Returns During Periods of Rising Rates
Periods of greater than 100 basis-point rise in the 10-year U.S. Treasury yield. Month-end returns, annualized

Source: Morningstar. The historical data shown are for illustrative purposes only and do not represent any specific portfolio managed by Lord Abbett or any particular investment.
1Citigroup 10-Year Treasury Index. 2Bloomberg Barclays U.S. Aggregate Bond Index. 3Bloomberg Barclays U.S. Floating Rate Note Index. 4BofA Merrill Lynch U.S. Corporate BBB-Rated 1-3 Year Index. 5Credit Suisse Leveraged Loan Index. 6BofA Merrill Lynch High Yield Master II Index. 7BofA Merrill Lynch All Convertibles Index. 8S&P 500 Index.

 

4. Portfolio diversification—As one may surmise from the data in Chart 2, U.S. convertible bonds historically have had negative correlation with U.S. Treasury bonds and zero correlation with the representative Bloomberg Barclays U.S. Aggregate Bond Index. Adding convertibles to an investment-grade bond portfolio provides diversification benefits, while lowering the interest-rate sensitivity of the overall portfolio. Convertibles do, however, have positive correlation with equities, though they are not perfectly correlated: over the long term, adding convertibles would have increased total returns, while lowering volatility versus a pure equity portfolio. 

 

Table 2.  A Low or Negative Correlation with Bonds Provides Diversification Benefits

Source: Zephyr. The historical data shown are for illustrative purposes only and do not represent any specific portfolio managed by Lord Abbett or any particular investment.

 

In addition, adding convertibles to an equity portfolio may broaden exposure to parts of the equity market that may be underrepresented in an investor’s portfolio. This is especially true of many dividend-focused equity strategies that tend to have a larger-cap, value tilt. Although the convertible market is represented by companies of all market capitalizations, convertibles have a heavier weighting to small- and mid-cap companies than most dividend strategies. Approximately one-third of the market value of the BofA Merrill Lynch U.S. Convertible Index is comprised of companies with a market cap of less than $5 billion; when measured by issuer, the number of companies below $5 billion jumps to more than two-thirds of the index. With a current yield that is more than double the dividend yield of the Russell 2000® Index, U.S. convertible bonds may provide an attractive source of income, while providing exposure to the growth potential of smaller companies that typically do not have high dividends.  

With significant allocations to growth-oriented sectors such as technology and health care, a convertible strategy may be an attractive complement to a traditional dividend strategy focused on large- and mega-cap value stocks.         

 

Chart 2. Convertibles May Offer an Income Advantage over Stocks
(Data as of 4/30/2017)

Sources: BofA Merrill Lynch, Standard & Poor’s, and  Russell. The historical data shown are for illustrative purposes only and do not represent any specific portfolio managed by Lord Abbett or any particular investment.
Convertibles are represented by the BofA Merrill Lynch U.S. Convertibles Index. Large caps are represented by the S&P 500 Index. Mid-cap stocks are represented by the Russell Midcap® Index. Small-cap stocks are represented by the Russell 2000® Index.

 

Navigating the Market
Significant resources are required to successfully navigate the unique characteristics of this asset class.  Rigorous credit analysis of a company’s balance sheet, cash flow, and liquidity position is necessary to properly evaluate the fixed-income component of a convertible. Fundamental equity analysis must be done to identify undervalued companies with the potential for price appreciation in the underlying equity. And expertise in the convertible structure is needed in order to understand the value of the option to convert, and how changes in the price and volatility of the underlying stock will translate to the performance of the convertible. An experienced investment team with expertise in multiple areas (credit and equity research, convertible bond portfolio management, research, and trading) can take advantage of opportunities and mis-pricings that can frequently occur within the asset class. 

Moreover, given the nature of the asset class, an active manager can adjust the portfolio to adapt to the market environment, moving up or down in credit quality, rotating across sectors and market capitalizations, or modifying the portfolio’s equity sensitivity.

Role in a Portfolio
Although, as we said, convertibles do not fit neatly into a style box, they can, however, play a valuable role in a portfolio for investors who are looking to diversify a traditional bond portfolio, those who are seeking sources of income that may do well during periods of rising rates, or those who want to maintain exposure to the upside of the equity market, albeit with reduced volatility. The unique return profile and diversification benefits of convertibles also may present attractive opportunities for a flexible manager within a multi-sector bond or multi-asset-class portfolio.  

 

CONTRIBUTING STRATEGIST

RELATED FUND
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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