"In the first place, an ounce of prevention is worth a pound of cure." — Benjamin Franklin
Convertible bonds are all grown up. Investors looking for ways to reduce risk and increase returns often try diversifying their portfolios through investments in various asset classes, but many of them overlook convertibles because they don't realize the significant structural changes these instruments have undergone.
Today's convertible bonds possess features that capture the upside of the equity market, while providing significant protection on the downside, and superior returns. Shorter maturities of five to seven years rather than 25 to 30 offer better downside protection, and longer call protection offers better upside participation vs. the underlying stock.
Equity performance or convertible performance? Nobody can tell
Over full market cycles, including the past 10-year equity bull market, convertibles have delivered equity-like returns, with lower risk and a higher Sharpe ratio than equities. Since 1973 through March 2017, convertibles closely tracked the performance of the Standard & Poor's 500 stock index, with lower risk. During that time, convertibles significantly outperformed more frequently used fixed-income asset classes, as evidenced by Figure 1.
In addition to capturing a large portion of the underlying equity market upside, convertibles also typically outperformed in equity market sell-offs, as the bond floor provided downside protection and the coupon helped to counter equity market depreciation. During the sharp market correction that spanned November 2007 to February 2009, convertibles also suffered a meaningful decline primarily attributable to the poor performance of the overleveraged convertible arbitrage hedge funds.
But today, the number of relevant convertible arbitrage hedge funds has declined sharply to fewer than 20, from a peak of more than 200. In addition, with prime brokers no longer providing the same levels of leverage to this dramatically smaller pool of convertible arbitrage hedge fund managers, long-only investors have stepped in to take a lot more of the convertible market. This shift has played a critically important role in the positive structural transformation of the post-2008 convertible bond era.
After the 2009 market bottom, domestic equity markets have risen steadily without much interruption. According to the Bank of America Merrill Lynch All US Convertible index, if the average annual performance dating back to Jan. 1, 2007, is considered, convertibles have captured 93% of the S&P 500's upside.
Given the downside protection inherent in the asset class, the risk-adjusted performance of convertibles vs. equities is also important to consider. According to Bloomberg, over the past 10, 15 and 20 years, convertibles have generated returns in line with equities, with a lower standard deviation and a higher Sharpe ratio. By including convertibles as part of a fixed-income allocation, investors have historically received equity-like returns with diversification benefits. Yet, including convertibles as part of an equity allocation might also provide a more conservative, risk controlled exposure without sacrificing significant upside performance. If this buoyant market experiences a sudden loss of pressure, convertibles are well-positioned to preserve more capital than their underlying common stock and may represent a prudent risk-managed approach to market exposure.
Little protection has been required since the market bottom in 2009, and equity valuations are currently near all-time highs. Extended equity markets, rising interest rates and increased volatility are historically conducive to convertible outperformance. The Chicago Board Options Exchange Volatility index was established to reflect a market estimate of future volatility (see Figure 2). The VIX was recently held to persistently low levels, notwithstanding a recent six-day span when it moved up 57%. Typically, increased volatility portends a market top, or a market bottom.
Considering the current S&P 500 levels, the greatest current risks appear to be heavily skewed toward a downside scenario. Either way the market moves, recent price action of the VIX might be indicative of increased future volatility. If equity markets are at an inflection point, a convertible allocation is likely to provide an ounce of prevention in a diversified portfolio. When volatility rises above current historically low levels, the embedded option in convertible securities should also increase in value, thereby providing an opportunity to capitalize on the increased volatility.
Eight years of global central bank stimulus has fueled markets to recent highs. Rational or not, global financial markets have been on a strong upward trajectory and the United States Federal Reserve Bank has taken notice. Although the Fed already incrementally raised rates at the March and June Federal Open Market Committee meetings, Fed bankers have penciled in at least one additional rate hike into their 2017 forecasts. Convertibles have historically performed well in various macroeconomic conditions, including when the U.S. dollar rises and when the price of oil increases. If these prior trends and relationships hold, investors would be wise to carefully consider initiating or increasing their convertible allocations in order to diversify their traditional fixed income exposure.
In Figure 3, we illustrate how convertibles have outperformed other fixed-income asset classes in periods of rising interest rates. In fact, when looking back to 1992 during periods when 10-year interest rates rose at least 100 basis points (nine such periods) convertibles outperformed all other fixed-income securities six out of the nine times. There are several factors driving this outperformance. Rising rates historically accompany generally improving macroeconomic conditions, stronger corporate profits, and upward trending equity markets. As a result of strengthening equity markets, the embedded equity option appreciates and drives the relative outperformance of convertibles vs. other common fixed-income securities. Convertibles also benefit from having shorter duration relative to straight bonds, thereby reducing interest rate sensitivity.
In the past, periods of rising rates have been accompanied by strong convertible new issuance. In fact, year-to-date through May, corporations raised approximately $35 billion globally through issuing convertible securities. This represents a 50% year-over-year increase, according to UBS/Thomson Reuters.
An ounce of prevention
Over the long term, convertibles have proven to be a useful portfolio diversifier. They typically capture much of the equity market upside while providing downside protection and low correlation to other fixed-income asset classes. Over full market cycles, they also typically deliver an equity-like return, a higher Sharpe ratio and a lower standard deviation compared to common stock.
The addition of convertible securities provides the potential to improve most portfolios' efficient frontiers by offering highly compelling risk-adjusted returns.
While convertibles have historically provided very strong risk/return characteristics for investors, the convertible market has undergone a significant positive structural transformation during the past decade, which provides an even more compelling risk-return profile for the future. Shorter maturities have improved downside protection, longer call protection has helped to increase equity market participation, and the ownership shift to more stable long-only investors from levered hedge funds have all contributed to make the asset class even more attractive.
Since 1973, the broad convertible market has closely tracked the performance of the S&P 500 with lower risk by providing downside protection and the ability to allow investors to sleep calmly at night. Whether markets continue to rise or start to sell off, convertibles represent the capital markets' ounce of prevention in anticipation of more challenging markets, and its pound of cure during periods of high turbulence and distress.
Tracy Maitland is president and chief investment officer, and Robert Farmer and Hart Woodson are managing directors, portfolio management, with Advent Capital Management LLC, New York. This content represents the views of the authors. It was submitted and edited under P&I guidelines, but is not a product of P&I's editorial team.