Using Convertible Bonds to Help Weather Volatility | Lord Abbett
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Market View

Convertible bonds can potentially provide downside protection during stock-market downdrafts. Here’s how. 

Read time: 3 minutes

Through the end of August, stock markets had posted exceptional performance despite headline events and economic volatility in 2021. Since the end of 2019, the S&P 500® Index had climbed over 43% through the end of August on an absolute basis, including the reinvestment of dividends. Soaring corporate earnings had supported returns, with companies in the S&P 500 reporting record levels of net income in the first and second quarters of this year. Enthusiasm for stocks was also bolstered by low yields on fixed-income investments and increased liquidity from stimulus programs.

Then came September. Equity investors began to contemplate potential headwinds such as the prospect of tapering by the U.S. Federal Reserve and concerns about a slowing pace of U.S. economic growth. Financial troubles at giant Chinese property developer, China Evergrande Group, also weighed on sentiment. As a result, the market saw a fresh bout of selling, just in time for the historically volatile fall months. S&P 500 losses for the month totaled 3.6% through September 21.

Perhaps equity prices were due for a reset after their strong 2021. The last meaningful decline in the stock market, as measured by the S&P 500 index, was October 2020, when the index declined 7.4% between October 13, 2020 and October 30, 2020. More recent dips in 2021 have not reached 4%.

Seeking Lower Volatility

Given recent trends, investors might be concerned about further potential episodes of equity volatility in the coming months, as companies’ earnings growth and profit margins adjust to normal levels. Geopolitical risks are also a potential disruptor, and geopolitical events have more influence today on the global economy and global investment markets.

One approach many investors have embraced is allocating to stocks that have exhibited low volatility. This strategy generally works to protect assets during tough periods in the market; the representative S&P 500® Low Volatility Index (low-vol index) has displayed an average of 61% downside capture in market drawdowns greater than 10% in the last 35 years (see Figure 1).

However, that protection has come with a cost. The low-vol index has lagged the broader market index by 6.5% on an annualized basis in the last five years ending August 2021. The composition of the low-vol index is a big reason why. The largest sector concentrations in the index are in consumer staples and utilities, with healthcare, industrials, and financials rounding out the top five. Those high-quality sectors do a good job of defending downside but are limited in their responsiveness to improving economic conditions, and particularly limited in their exposure to the disruptive growth themes that have carried the market over the last 10 years.

The representative convertible bond index listed in Figure 1 has similar downside protection properties to low-volatility stocks, averaging 67% downside capture during those same big selloffs. However, that protection is achieved in a different way. Remember, even if the price of the shares underlying a convertible bond falls, the bond still pays interest and is positioned to repay its principal in the future barring any negative credit events. The value of these payments represents the bond floor. The bond floor’s higher position in the issuing company’s capital structure becomes more important in those market selloffs. Said another way, convertible bonds become more like bonds when things get rough and more like stocks when things are going well, a feature known as positive convexity.

 

Figure 1. Downside Capture: Convertible Bonds versus Low-Volatility Stocks
Returns and downside capture during U.S. equity market declines greater than 10%

Source: Bloomberg Index Services Limited. Data represents historical periods of stock market declines. Past performance is not a reliable indicator or guarantee of future results. Max intra-year declines, starting 1/1/1990. Start dates inclusive. 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.

 

Note the significant variation in performance between convertible bonds and low-volatility equity in each period. This diversification effect occurs because the convertibles market is composed of very different issuers than the types of companies in the low-volatility index (see Figure 2). The dynamic growth companies that the low-vol index lacks are plentiful in the convertibles market, with information technology, consumer discretionary, and communication services sectors more heavily represented. 

 

Figure 2. Significant Differences in Sector Weightings of Convertible Index and “Low-Vol” ETF
Sector exposures within the ICE BofA U.S. Convertible Bond Index and an S&P 500 low-volatility- related ETF as of July 7, 2021

Source: Bloomberg Index Services Limited and ICE Data Indices. Data as of July 7, 2021. S&P low-volatility ETF based on Invesco S&P 500 Low Volatility ETF, which is an exchange-traded fund that tracks the S&P 500 Low Volatility Index. The ETF’s sector exposure is unconstrained and rebalanced quarterly. Convertible Index sectors mapped to the Global Industry Classification Standard (GICS®) sectors for comparison purposes. Info Tech=Information Technology. Comm Services=Communication Services. Consumer Discr=Consumer Discretionary. 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.

 

Why is that important? In periods (which have been many in the last 10 years) when innovative growth companies take market share from well-established, high-quality competitors, and investors expect continued disruption, exposure to convertible bonds can help balance the impact on low-vol equities. We think this diversification strategy should be a part of investors’ thinking when they consider approaches to defend their portfolios from volatility risk.

 

Unless otherwise noted, all discussions are based on U.S. markets and U.S. monetary and fiscal policies.

Asset allocation or diversification does not guarantee a profit or protect against loss in declining markets.

No investing strategy can overcome all market volatility or guarantee future results.

The value of investments and any income from them is not guaranteed and may fall as well as rise, and an investor may not get back the amount originally invested. Investment decisions should always be made based on an investor’s specific financial needs, objectives, goals, time horizon, and risk tolerance.

Market forecasts and projections are based on current market conditions and are subject to change without notice.

Projections should not be considered a guarantee.

Equity Investing Risks

The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. While growth stocks are subject to the daily ups and downs of the stock market, their long-term potential as well as their volatility can be substantial. Value investing involves the risk that the market may not recognize that securities are undervalued, and they may not appreciate as anticipated. Smaller companies tend to be more volatile and less liquid than larger companies. Small cap companies may also have more limited product lines, markets, or financial resources and typically experience a higher risk of failure than large cap companies.

Fixed-Income Investing Risks

The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Generally, when interest rates rise, the prices of debt securities fall, and when interest rates fall, prices generally rise. High yield securities, sometimes called junk bonds, carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Bonds may also be subject to other types of risk, such as call, credit, liquidity, and general market risks. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer the maturity of a security, the greater the effect a change in interest rates is likely to have on its price. The securities markets of emerging market countries tend to be less liquid, especially subject to greater price volatility, have a smaller market capitalization, have less government regulation and may not be subject to as extensive and frequent accounting, financial and other reporting requirements as securities markets in more developed countries. Further, investing in the securities of issuers located in certain emerging countries may present a greater risk of loss resulting from problems in security registration and custody or substantial economic or political disruptions.

The credit quality of fixed-income securities in a portfolio is assigned by a nationally recognized statistical rating organization (NRSRO), such as Standard & Poor’s, Moody’s, or Fitch, as an indication of an issuer’s creditworthiness. Ratings range from ‘AAA’ (highest) to ‘D’ (lowest). Bonds rated ‘BBB’ or above are considered investment grade. Credit ratings ‘BB’ and below are lower-rated securities (junk bonds). High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer’s ability to pay interest and principal on these securities.

This material may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

The views and opinions expressed are as of the date of publication, and do not necessarily represent the views of the firm as a whole. Any such views are subject to change at any time based upon market or other conditions, and Lord Abbett disclaims any responsibility to update such views. Lord Abbett cannot be responsible for any direct or incidental loss incurred by applying any of the information offered.

This material is provided for general and educational purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, or any Lord Abbett product or strategy. References to specific asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations or investment advice.

Please consult your investment professional for additional information concerning your specific situation.

Glossary & Index Definitions

Bond floor refers to the minimum value a convertible bond should trade for, based on the discounted value of its coupons plus redemption value.

Convexity, a measure of the curvature in the relationship between bond prices and bond yields, illustrates how the duration of a bond changes as the interest rate changes. Negative convexity occurs when a bond's duration increases as yields increase; positive convexity occurs when a bond's duration rises, and yields fall.

Downside/Upside capture: These ratios measure a manager’s performance in down or up markets relative to a particular benchmark. A down market is one in which the market’s quarterly (or monthly) return is less than zero; an up market is greater than zero. For example, a downside capture ratio of 50% means that the portfolio’s value fell half as much as its benchmark index during down markets.

Duration is a measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates.

The yield on a security is the amount of cash (in percentage terms) that returns to the owners of the security, in the form of interest or dividends received from it.

The ICE BofA U.S. Convertible Index contains issues that have a greater than $50 million aggregate market value. The issues are U.S. dollar-denominated, sold into the U.S. market and publicly traded in the United States.

ICE BofA Index Information:

Source ICE Data Indices, LLC (“ICE”), used with permission. ICE PERMITS USE OF THE ICE BofA INDICES AND RELATED DATA ON AN “AS IS” BASIS, MAKES NO WARRANTIES REGARDING SAME, DOES NOT GUARANTEE THE SUITABILITY, QUALITY, ACCURACY, TIMELINESS, AND/OR COMPLETENESS OF THE ICE BofA INDICES OR ANY DATA INCLUDED IN, RELATED TO, OR DERIVED THEREFROM, ASSUMES NO LIABILITY IN CONNECTION WITH THE USE OF THE FOREGOING, AND DOES NOT SPONSOR, ENDORSE, OR RECOMMEND LORD ABBETT, OR ANY OF ITS PRODUCTS OR SERVICES.

The S&P 500® Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries. 

The S&P 500® Low Volatility Index measures performance of the 100 least volatile stocks in the S&P 500. The index benchmarks low volatility or low variance strategies for the U.S. stock market. Constituents are weighted relative to the inverse of their corresponding volatility, with the least volatile stocks receiving the highest weights. Volatility is defined as the standard deviation of the security computed using the daily price returns over 252 trading days.

Indexes are unmanaged, do not reflect deduction of fees and expenses and are not available for direct investment. 

This material is the copyright © 2021 of Lord, Abbett & Co. LLC. All Rights Reserved. 

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