Investing With The Top Down

7/10/2017


In today's environment of strong but increasingly risky equity markets coupled with rising interest rates, convertible securities seem especially attractive. However, be aware — convertible securities are really stocks dressed up like bonds, and not the other way around. That distinction has important implications for how investors should use this asset class.

Convertible securities combine characteristics of stocks and traditional fixed-income securities. Convertibles come in two flavors — convertible bonds and convertible preferred stocks.

Convertible bonds feature a coupon rate and a fixed maturity date, just like traditional bonds. As part of the company's debt structure, they have preferential treatment versus equity in cases of bankruptcy. Like nonconvertible preferreds, convertible preferred stock pays a fixed dividend rate, which carries precedence over the dividend paid on common shares.

Most of these convertibles can, under certain conditions, be exchanged or converted into a specific number of shares of the issuer's common stock.

Convertible securities allow companies to raise capital in a more cost-friendly manner. Firms can issue convertibles at lower coupon rates than comparable nonconvertible debt, since investors will accept less interest in exchange for the ability to convert to equity.

For investors, convertibles have a number of appeals:

Historically, convertible securities have participated in a greater portion of the stock market's upside than its downside. The table below shows, in five-year increments, the returns of convertibles versus stocks and nonconvertible corporate bonds over the last 25 years. For the full 25-year period, convertibles captured 96% of the S&P 500 Index's annual return of 9.2% at a lower risk level, as measured by standard deviation.

CONVERTIBLES OFFER STOCK-LIKE RETURNS
Convertible
------ Bonds ------
------ Equities ------
Long-Term
-- Corporate Bonds --
Intermediate
-- Corporate Bonds --
Time Period
Annual
Return
(%)
Standard
Deviation
(%)
Annual
Return
(%)
Standard
Deviation
(%)
Annual
Return
(%)
Standard
Deviation
(%)
Annual
Return
(%)
Standard
Deviation
(%)
1992-1996
14.3
7.1
15.2
8.7
8.9
7.0
7.7
4.3
1997-2001
9.4
16.0
10.7
17.9
7.3
6.4
7.1
3.2
2002-2006
7.8
8.5
6.2
12.4
7.5
8.7
5.5
4.0
2007-2011
2.1
16.2
(0.3)
18.9
8.5
12.6
6.3
6.1
2012-2016
11.0
8.5
14.7
10.4
5.4
8.3
3.6
2.8
1992-2016
8.8
11.9
9.2
14.2
7.5
8.8
6.0
4.2
The asset classes are represented by: convertibles, BofA ML All-U.S. Convertible Index; equities, S&P 500 Index; long-term corporate bonds, Bloomberg Barclays U.S. Long Corporate Index; intermediate corporate bonds, Bloomberg Barclays U.S. Intermediate Corporate Index.      Source: Morningstar, Calamos Investments.

Convertibles typically do better than conventional bonds in periods of rising interest rates. Because convertibles usually feature shorter maturities (oftentimes three to five years), duration is lower, which makes them less sensitive to interest-rate movements. Also, in rising-rate environments, which tend to pinch traditional bonds, convertibles may favor the returns of the equity market.

For example, in the second half of 2016, the interest rate on 10-year Treasury note increased to 2.45% from 1.49%. Reflecting the rise in interest rates, the benchmark Barclays Aggregate Bond Index declined nearly 3%. However, convertibles (as benchmarked by the Bank of America ML All U.S. Convertibles Index) rose 7%, not far from the approximately 8% return of the S&P 500.

Convertibles make for interesting alternative investments when speculating in aggressive stocks. Technology and health-care firms comprise a significant chunk of the convertible market. Within these sectors are a number of high-growth, high-risk, non-dividend-paying companies that have issued convertible securities. Convertibles offer a way to capture a portion of the upside of these stocks and generate cash flow not available via the common stock, all at a lower risk level than the common. 

Examples of aggressive special-situation stocks with convertibles include Tesla ($327; TSLA), Twitter ($18; TWTR), and Clovis Oncology ($94; CLVS). Please note the Forecasts does not recommend these three stocks. We simply provide them as examples of the types of high-risk, high-reward companies that tend to offer convertibles.

Before you decide to invest in convertibles, make sure you understand what they aren't. Convertibles are often positioned as a stock/bond hybrid. However, the return relationship is not a 50/50 split between stocks and bonds. Indeed, convertibles have historically performed much more like stocks than bonds.

For example, from November 2007 through February 2009, when the S&P 500 declined more than 41%, the convertible-bond market saw a 32% decline. In contrast, the Barclays Aggregate Bond Index rose 4.5% over the same period.

Bottom line: If you invest in bonds in search of income and risk reduction relative to the stock market, don't buy convertibles. Alternatively, if you invest in stocks but would like a slightly higher level of cash flow and a slightly lower level of risk relative to the broad stock market, a position in convertible bonds can serve as a useful hedge to the equity portion of your portfolio.

You can invest in convertibles using an exchange-traded fund. SPDR Bloomberg Barclays Convertible Securities ($50; CWB) has gained 10% so far this year. With assets of nearly $4 billion, this ETF is the biggest in the convertible space. The fund charges an annual expense ratio of 0.40%. A smaller option is the iShares Convertible Bond ($52; ICVT), with assets of $185 million. The fund, up 9% year-to-date, has an expense ratio of 0.20%.


Current Hotline

Stock Spotlight

Individual Stock Reports

ISRs make stock research easy!

Perhaps the most valuable two page reports available anywhere.

All the data you would normally have to plow through years of 10-K filings, earnings reports, and reams of market data to assemble — yours all in one concise report.

ISRs contain our proprietary Quadrix scores — find out how we rate all the stocks in the S&P 500.

Visit us at individualstockreports.com