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Fund Spy

Making Sense of Convertible Bonds and Where to Find Them

This niche corner of the bond market may be worth a look.

Convertible bonds can be an attractive option for investors looking to supplement their income needs without sacrificing growth opportunities. These hybrid securities incorporate both bond and equity features. They have an embedded call option that provides the holder the right to convert the bond into common stock of the issuing firm at a predetermined (conversion) price. But if the stock price tumbles, the convertible’s interest and principal payments help limit losses.

As a result, convertibles tend to be correlated to equities, experiencing some but not all of the equities' upside with less of the downside risk. Still, this profile can vary given the different types: These bonds can be busted, equity-sensitive, or balanced. Prices for busted convertibles are below the securities' par value, and they tend to act more like a corporate bond while equity-sensitive convertibles have prices above par and tend to trade in tandem with a company's common stock. Balanced convertibles exhibit characteristics of both, leading to the asymmetric profile that many investors favor. These hybrid securities are senior to equity in the capital structure but usually subordinate to traditional bonds.

The convertible-bond market is a drop in the bucket compared with more-traditional debt segments like investment-grade corporates, mortgages, and government-related bonds. As of the third quarter of 2020, the U.S. convertible-bond market stood at $300 billion (almost 75% of the global convertibles market), with most companies skewed to the larger end of the market-capitalization spectrum. Many of the companies that issue convertible bonds can be found within the technology or healthcare industries; these two industries account for roughly half of the commonly used ICE Bank of America Merrill Lynch All U.S. Convertibles Index benchmark. High-growth companies like semiconductor Microchip Technology (MCHP), payments company Square (SQ), and telehealth provider Teladoc Health (TDOC) have issued large amounts of convertible debt in the past few years. Strong rallies within their common stock have contributed to solid returns within their convertible-debt structures, helping drive up this larger share of the bogy.

Convertibles’ Benefits on Display
The traditional correlation patterns for convertible bonds have held fast even with these more recent industry shifts. The ICE Bank of America Merrill Lynch All U.S. Convertibles Index exhibited 89% and 13% correlations with the S&P 500 and Bloomberg Barclays U.S. Aggregate Bond Index, respectively, over the trailing 15 years ended October 2020. Those correlations were similar over the past three years.

Recently, this behavior was on display as the coronavirus roiled markets in early 2020. Between the market’s Feb. 20 peak and March 23 trough, the average convertible strategy sank 24% while large-blend equity strategies on average suffered a deeper 34% loss. Intermediate-term bond strategies, which typically benchmark to the Aggregate Index, fell just 3%. Federal Reserve action in late March provided the markets with much needed support, which helped risk assets rocket upward. From the market nadir through the end of October 2020, convertibles outpaced the large-blend equity funds by 5 percentage points with a 52% gain. Convertibles benefited from a deluge of issuance that the market easily absorbed, as well as a significant tilt to technology companies that benefited from the shift to virtual services in the “work from home” environment.

Convertibles have held up better than large-cap equities during other challenging markets. For example, the convertible category fell by 30% on average during the great financial crisis while the large-blend equity category sank to greater depths with a 41% loss. Convertible strategies also proved to be more effective at limiting losses during risk-off periods like the eurozone sovereign debt crisis in 2011 and the last quarter of 2018 relative to large-cap equities. Despite losses of 15% and 9% during those periods, the convertibles category maintained a 2- and 4-percentage-point lead over the average large-cap fund. Convertible bonds’ downside protection, combined with their equity sensitivity, have made for competitive returns over the long-term versus large-blend equities as well as much higher gains compared with traditional debt categories. Over the trailing 15 years through October 2020, the typical convertible-bond strategy notched a healthy 8% gain, which was on par with the average large-cap equity fund. This return was a couple of percentage points ahead of the high-yield bond category average and nearly double the result of the intermediate core bond category norm.

Dedicated Convertibles Options
There aren’t too many dedicated convertible strategies out there, but a few stand out. The team behind AllianzGI Convertible Securities (ANNPX) applies disciplined portfolio construction and risk management processes that have contributed to category-leading performance over the long term. Over the trailing five years ended October 2020, the strategy, which has a Morningstar Analyst Rating of Silver, experienced approximately 94% of the S&P 500 index’s downside while capturing 147% of the market’s upside. That strategy emphasizes balanced convertibles while tilting equitylike and busted convertibles in accordance with the team’s views and market conditions. Most positions account for 1% to 2% of assets, while common stock is rarely held, helping limit risk.

Columbia Convertible Securities (NCIAX) (also rated Silver) applies a similar approach here but does so with a more aggressive bent. Positions tend to be concentrated (many between 1% and 3%), with the occasional name exceeding 5% of assets. Electric-vehicle maker Tesla (TSLA), one of the largest issuers in the convertible space, accounted for almost 7% of the portfolio as of September 2020. Concentrated bets and smart picks within the common stock stake (typically 3%-5% of assets) have helped the strategy outpace peers during market recoveries. Overall, this approach has contributed to greater upside (153%) but greater downside capture (118%) over the past five years.

Bronze-rated MainStay MacKay Convertible (MCNVX) uses a more restrictive investment framework than many of its peers through its exclusion of companies with small market capitalizations and little convertible debt outstanding. The team also removes bondlike convertibles and closely monitors its equitylike bond exposure in order to maintain an asymmetric profile. Despite the guardrails, the strategy’s performance on the downside has been somewhat disappointing. Modest overweightings to energy names plagued the portfolio as oil prices have remained stubbornly low. Still, it remains an appealing option and has generally topped peers during market recoveries.

Other Strategies That Invest in Convertibles
Convertible bonds are featured within more credit-focused strategies as well, but only in small doses. Loomis Sayles applies an aggressive, often-contrarian approach with an emphasis on corporates across its Loomis Sayles Bond (LSBDX) and Loomis Sayles Strategic Income (NEZYX) strategies (both rated Silver). These flexible multisector bond offerings have long made significant use of convertibles and often hold between 5% and 10% of assets in each.

Convertibles can also be found within the high-yield bond Morningstar Category, but few players operate in the space to the extent that Pioneer High Yield (TAHYX) and Osterweis Strategic Income (OSTIX) (both Neutral-rated) do. Both strategies have long used convertible bonds for their unique structure and asymmetric return profile. Allocations typically stand between 5% and 10% of assets for each of these options.

All told, convertible securities can be beneficial to income-seeking investors who are comfortable with more equitylike risk. It’s important to remember that the convertible-bond market is a niche corner of the market that requires specialization and robust tools and resources to analyze these unique structures. Investors should carefully evaluate a convertible strategy’s approach to portfolio construction as well as the underlying types of convertibles because they could end up with something that mirrors an equity fund without the downside protection benefit.

Zachary Patzik does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.