As a hybrid asset class, convertible securities combine upside potential associated with equities with a coupon payment and bond-like floor. With generally higher yields than stocks and low correlations to fixed income sectors, convertibles have become a powerful tool for investors seeking growth, income, and diversification.
Convertible securities are corporate bonds with an embedded option that allows investors to convert bonds into the common stocks of the issuing company. Behaving similarly to bonds when the underlying equity falls and more like stocks when the underlying equity rises, convertibles offer a potential cushion in stormy markets due to the bond-like floor, while also allowing investors to capture equity-like upside potential.
When you hold a convertible security, you have the right, but not the obligation, to convert the bond into a predetermined number of shares. The number and type of shares that can be converted are set out in a convertible security’s offering documents. If you monitor the value of the bond in comparison with the value of the converted shares, you can choose to convert when the share is worth more than the bond.
Figure 1 illustrates how, as the stock price gets closer to or above the conversion price, the value of the convertible bond typically rises, becoming more sensitive to the change of the underlying stock price (high delta) and taking on more stock-like characteristics. On the other hand, when the stock price falls below the conversion price, the convertible behaves more like a bond, and its value typically does not fall as much as the stock because the coupon and principal value of the bond create investment value (bond floor).
Figure 1: The Payoff of Convertibles
Convertibles combine an anticipated downside risk mitigation of bonds with equity-like upside potential. Their hybrid nature supports a range of asset allocation goals based on historical data as shown below:
Growth Equity Exposure for Upside Potential – The option to convert to equities allows investors to participate in some of the upside of rising equity market. And given that convertible financing is particularly attractive for growth companies, which tend to exhibit strong earnings and sales growth but with low cash flows, convertible bonds often provide growth-oriented exposure, as shown in Figure 2.
Figure 2: Convertible Securities Return-Based Style Analysis
Higher Yield than Equities – Because of the value of the option to convert, the yield of convertible bonds is usually lower than that of nonconvertible corporate bonds from the same issuer. However, over the past 10 years, convertibles have provided a higher yield than equities and the traditional core fixed income segment, as represented by the Bloomberg U.S. Aggregate Index (Agg). See Figure 3.
Figure 3: 10-Year Monthly Average Yield
Lower Volatility and Less Drawdown than Equities – Convertibles’ periodic fixed coupon payment and the return of the principal value at maturity (if not converted before maturity) can potentially provide downside risk mitigation that is absent in equities. As shown in Figure 4, convertibles have experienced lower volatility and typically lower drawdown than the broader equity market over the past 15 years. And, in the event of default, convertible bondholders are paid out before common stockholders.
Figure 4: 15-Year Volatility and Max Drawdown
Lower Correlation to Rate-Sensitive Fixed Income Sectors – With their unique risk/reward profile, convertibles have historically exhibited low correlations to traditional interest rate-sensitive bond sectors,1 making them a potential portfolio diversifier. Figure 5 shows how adding convertibles to a fixed income and equity asset allocation may potentially improve portfolio returns without increasing risk.
Figure 5: Enhanced Risk or Return Profile by Adding Convertibles
While issuers of convertibles range across the spectrum of credit quality — investment grade, non-investment grade and non-rated — a large portion of the market remains unrated because bond rating programs can be expensive and time-consuming to set up for companies accustomed to raising capital through equity. Additional potential risks with convertibles include:
Convertible securities’ historically low volatility relative to traditional equity indices, combined with their income stream, can potentially provide diversification benefits, which can make them a useful portfolio construction tool.
Due to the unique features described earlier, you can integrate convertibles into your portfolios with these goals in mind:
With a gross expense ratio of 0.40%, CWB may be compelling vehicle for accessing the traditionally illiquid convertibles market in a cost-efficient way. CWB’s index is designed to represent the market of U.S. convertible securities, such as convertible bonds and convertible preferred stock, with an issue amount of at least $350 million and a par amount outstanding of at least $250 million.3
Conversion Price – The price per share at which a convertible security can be converted into common stock. It is equal to the par value of the convertible bond divided by the conversion ratio.
Investment Value (Bond Floor) – The value of a bond with the same terms and feature but without the conversion option.
Parity – The value of the underlying equity if the convertible is converted. It is equal to the current stock price multiplied by the number of shares for which the bond may be exchanged.
Conversion Premium – The difference between the price of the convertible and the parity.
1Source: Bloomberg Finance, L.P., Bloomberg U.S. Convertible Liquid Bond Index has 0.31 correlation of monthly returns to the Bloomberg U.S. Aggregate Bond Index over the past 10 years ending 12/31/2022.
2Source: Bloomberg Finance, L.P., FactSet, as of 12/31/2022. Bloomberg U.S. Convertible Liquid Bond Index has 0.31 correlation of monthly returns to the Bloomberg U.S. Aggregate over the past 10 years ending 12/31/2022. 10-Year Monthly Average Yield is 3.10% for Bloomberg U.S. Convertible Liquid Bond Index, and 2.39% for Bloomberg U.S. Aggregate Index. The average of the greater of current yield, yield to maturity, or yield to put for each issue is used for the Bloomberg U.S. Convertible Liquid Bond Index. Yield to Worst is used for Bloomberg U.S. Aggregate Index.
3Source: ssga.com, as of 12/31/2022.
Important Risk Information
The information provided does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. You should consult your tax and financial advisor.
The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without SSGA’s express written consent.
Investing involves risk including the risk of loss of principal.
This communication is not intended to be an investment recommendation or investment advice and should not be relied upon as such.
Issuers of convertible securities may not be as financially strong as those issuing securities with higher credit ratings and may be more vulnerable to changes in the economy. Other risks associated with convertible bond investments include: Call risk which is the risk that bond issuers may repay securities with higher coupon or interest rates before the security’s maturity date; liquidity risk which is the risk that certain types of investments may not be possible to sell the investment at any particular time or at an acceptable price; and investments in derivatives, which can be more sensitive to sudden fluctuations in interest rates or market prices, potential illiquidity of the markets, as well as potential loss of principal.
Bond funds contain interest rate risk (as interest rates rise bond prices usually fall); the risk of issuer default; issuer credit risk; liquidity risk and inflation risk. There are additional risks for funds that invest in mortgage-backed and asset-backed securities including the risk of issuer default; credit risk and inflation risk.
The trademarks and service marks referenced herein are the property of their respective owners. Third party data providers make no warranties or representations of any kind relating to the accuracy, completeness or timeliness of the data and have no liability for damages of any kind relating to the use of such data.
Non-diversified funds that focus on a relatively small number of securities tend to be more volatile than diversified funds and the market as a whole.
Passively managed funds invest by sampling the index, holding a range of securities that, in the aggregate, approximates the full Index in terms of key risk factors and other characteristics. This may cause the fund to experience tracking errors relative to performance of the index.
While the shares of ETFs are tradable on secondary markets, they may not readily trade in all market conditions and may trade at significant discounts in periods of market stress.