Convertible bonds are catching upside seekers' eyes

Featuring the dual benefits of safety and upside potential, the asset class is looking especially attractive

Convertible bonds are catching upside seekers' eyes

As the post-financial crisis bull run shows its age and bond yields continue to disappoint, investors are starting to shelve their long-applied playbook of seeking growth from securities. Many are shifting to more prudent priorities such as capital preservation or safety through diversification, prompting capital moves to fixed income or gold, to name some havens.

Another option that’s getting a second look: convertible bonds, which feature some of the safety of bonds as well as the upside potential of equities.

“Heading into the end of the year, some investors say the asset class is especially attractive: Stocks are hovering near records, yet concerns persist about an economic slowdown that could hit share prices hard,” the Wall Street Journal noted.

The Bloomberg Barclays U.S. Aggregate bond index has seen an 8.4% total return this year through Thursday, compared to the S&P 500 which has returned some 20% through Friday. Meanwhile, the BofA Merrill Lynch All U.S. Convertibles Index has gotten a total return of 15%, counting price changes and interest payments, for the year until Thursday.

“The convertibles index is on track for its best year since 2013, when it returned 25%,” the Journal said. Citing Dealogic, it added that total company sales of convertible bonds amounting to roughly US$43 billion for 2019 through Friday have been the highest since 2008.

In essence, the appeal of the asset class lies in their ability to be converted to shares if a company’s stock price reaches some pre-determined level. Since they are unsecured, holders of such bonds — assuming they haven’t been exchanged for shares — are paid after secured creditors in the event of a company bankruptcy, but they still take higher priority than shareholders.

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“The end of bull markets can be the most profitable part of the bull market,” explained Eli Pars, co-chief investment officer at Calamos Investments. That creates a blackjack-like situation for investors, who’d want to stay invested but also avoid taking a hit from when the market turns. Convertibles, Pars explained, present an opportunity for investors to “have [their] cake and eat it too.”

Like other forms of fixed income, convertible bonds have drawbacks. One is their volatility, which is lower than that for equities in general but still creates significant risk. Around this time last year, the asset class had returned almost 11% for 2018 up to that point; those returns had evaporated by year-end amid a general sell-off of riskier assets.

Convertible bond returns could also be hampered to a more limited extent if investors stand pat on their recent preference for underpriced stocks over shares of rapidly growing companies. As explained by the Journal, convertibles tend to be issued by growing companies, including many in the technology sector.

Another downside for investors at large is the fact that convertible bonds can trade more like stocks, particularly when equities trade well above conversion price of their associated convertible bonds. Should such a situation develop against a backdrop of a strong convertible-bond market, there can be a lot of unanticipated volatility.

“Investors, therefore, have generally welcomed the large amount of new convertible bonds entering the market since those sales have allowed them to pick up more bonds that trade closer to their face value,” the Journal said.

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