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Bond, Convertible Bond--A Secret Agent for Your Equity Allocation?

Convertible bonds are an often-overlooked asset class that might serve as an attractive alternative to stocks.    

Timothy Strauts, 09/11/2013

Convertible bonds are a niche asset class that often gets overlooked by most investors. There are currently only 16 mutual funds and just one exchange-traded fund that focus on the convertible-bond space. These funds have a combined $15 billion in assets. Investors' apparent lack of interest in this sector is somewhat surprising given that the Morningstar convertible-bond category has returned 7.6% annualized over the past 20 years. This beats the performance of the large-blend stocks category, which returned only 7.3% over the same period. Furthermore, convertible-bond funds achieved these returns with a risk level (measured by standard deviation) that was 22% lower than the large-blend category. Based on their track record, it would seem as though convertibles offer a compelling risk-adjusted return and could be a relatively less risky alternative to traditional equity investments.

The firm Butler|Philbrick|Gordillo & Associates has done research on the length of bull markets using data going back to 1871. It found that the median length of bull markets is 50 months and the median aggregate return during these bull runs has been 123%. Considering that the current bull market is 54 months long and the S&P 500 has climbed 152% over that period, it would appear that the current market rally may be drawing near its end. But that doesn't mean that investors should be trying to top tick the market and sell their equity holdings. After all, the longest bull market in history spanned from 1988 to 2000, and stocks had a cumulative return of 516% over that 12-year run. Instead, investors today may want to consider convertible bonds for a portion of their equity portfolios. This may provide investors the potential for equitylike upside with less downside risk.

To better understand the case for convertible bonds, it is important to understand how they work, how they compare with other equity alternatives, and how they perform in different interest-rate environments. It is also important to know what the options are for getting diversified exposure to the sector. The remainder of this article will cover each of these topics in turn.

What Is a Convertible Bond?
Convertible bonds are a hybrid security, having attributes of both fixed-income and equity securities. They are fixed-coupon bonds with a defined maturity date. They also grant the holder the option of exchanging the bond for common equity at a specified strike price. When issued, the strike price is usually 20%-30% higher than the current value of the stock. Many investors think of convertible bonds as a straight bond with an embedded call option. Because this embedded call option has some value to the end investor, the interest rate on a convertible will tend to be lower than that for a standard fixed-rate bond. The credit quality of companies issuing convertibles varies, but currently the average issuing firm has a credit rating of BB.

When investors buy convertible-bond funds, they get a collection of bonds with different performance characteristics depending on how the associated common stock has performed since the convertible was issued. If the stock has fallen in value, the convertible will behave more like a bond, and it will trade based on yield. If the stock has risen in value, the convertible will begin to trade more like the issuer's common stock. Owning a diversified basket of both of these "types" of convertibles in a fund blends the beneficial aspects of stocks and bonds together. The "equitylike" securities provide downside protection and income if the market performs poorly.

Bring on the Alternatives
High-yield bonds and long-short equity are two additional categories that investors have traditionally looked to as equity alternatives. Morningstar category return data is useful in making historical comparisons between these various types of equity alternatives. Category returns are calculated by taking a simple average of the returns for funds in a given category. Thus, Morningstar category returns provide an idea of what type of returns the average investor would have historically experienced in these asset classes.

Over the past 20 years there have been two major bear markets that provide an illustrative example of how these strategies perform in times of distress. The chart below shows the growth of $10, and the table provides a summary of the relevant performance statistics for each of these categories. The data shows that convertible bonds track large-blend stocks more closely than the other alternatives. Compared with large-blend stocks, convertibles have historically offered 77% of the upside with only 67% of the downside--as demonstrated by their upside and downside capture ratios in the table below. That may not sound impressive at first blush, but over the full period it meant that convertibles outperformed large-blend stocks on an absolute basis with lower volatility. During the 2008 financial crisis, convertible-bond funds performed poorly--losing 39.89% of their value--on average. That said, the category still fared better than the large-blend equity category. Large-blend stock funds lost 50.79% of their value--on average--during the most recent bear market.

High-yield bonds and long-short equity strategies are also positively correlated with large-blend stocks and historically have actually offered better downside protection than convertible bonds. However, as can be seen in the chart below, they haven't generated the type of equitylike returns that convertibles have.

Timothy Strauts is an ETF analyst at Morningstar.

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