Given their underlying equity option, convertible bonds can potentially provide a different risk/reward profile to a fixed-income investor's portfolio, industry sources said.
"The volatility of each convertible security will be more correlated to the moves in the underlying stock price vs. moves in broad interest rates," said George J. Cipolloni III, Philadelphia-based portfolio manager at fixed-income specialist Penn Mutual Asset Management. "If security selection is good, this can provide a buffer in a world of rising interest rates."
The advantage, Mr. Cipolloni added, is that there is the "potential for significant upside returns if the underlying stock rallies through the bond's conversion price." This upside could be much greater than the expected returns of non-convertible bonds, he noted.
Penn Mutual has assets under management of $33.6 billion.
The "majority" of investors that have a fixed-income allocation are seeking to "diversify their exposure away from interest rate and duration risk," said Michael Miller, the Wellesley, Mass.-based president and chief investment officer of convertible bond specialist Wellesley Asset Management Inc., with $3 billion in regulatory assets under management.
Based on recent flows and discussions with the financial community, Mr. Miller noted, "some institutional investors have begun to diversify their fixed-income exposure as others are in the early innings of this process. More investors are looking for ways to find income in a rising rate environment and convertible bonds are one solution for this."
New York-based Tracy Maitland, president and chief investment officer of alternative credit firm Advent Capital Management LLC, said Advent continues to see "active interest" from institutional investors and consultants that use this asset class in their asset allocation models as either conservative equity or as enhanced fixed income, while others "carve out a separate dedicated convertible allocation for this hybrid and differentiated asset class." Advent has about $10 billion in assets under management.
Mr. Cipolloni of Penn Mutual said the popularity of convertible bonds tends to move in tandem with demand for equities. "Investor demand for convertible bonds, just like demand in the credit market, became so hot (in 2021) that many companies were able to successfully issue zero-coupon convertible bonds," he said. "Again, this demand for convertibles tends to coincide with strong equity markets and after strong investment performance."
Convertible bonds as an asset class are in a "strong position" now, Mr. Miller noted, as issuance over the past two years has been "robust, replenishing the market with new bonds" for investors.
"We are very excited by this environment, as we are positioned to perform well as interest rates move higher and believe we have good downside protection if the equity markets pull back," Mr. Miller added.
