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A Boom Period for Convertible Bonds

Zachary Patzik, CFA

Zachary Patzik: 2018 proved to be an exciting time for convertible bonds. These hybrid securities comprise a corporate bond--which can provide downside protection and typically includes a fixed coupon payment to holders--as well as an embedded option that allows for upside participation if its corresponding equity appreciates. Their unique structure made for a tale of two periods, and we saw both a boom and bust in 2018--much like the equity market. Through the first three quarters of the year, the ICE Bank of America Merrill Lynch All US Convertible Index rose by 14.2%, while the S&P 500 and Bloomberg Barclays U.S. Aggregate Bond Index gained 14.3% and 1.6%, respectively.

Economic and political concerns spooked the markets at the beginning of the fourth quarter, which contributed to the sharp sell-off to end the year. As expected, convertibles fared better than their equity counterpart and managed to post a 20-basis-point return in 2018. Meanwhile, the S&P 500 dropped 4%, while the Agg gained one basis point.

The market for this niche security type is small relative to nearly all traditional bond sectors at around $200 billion. Despite the limited market size, there has been strong interest by investors and corporations alike. Convertible-bond issuance reached $51 billion in 2018, the highest level in a decade. Most portfolio managers and convertible specialists expect this strong issuance to continue into 2019 with rates likely to remain low and corporate fundamentals still intact. Through the end of the quarter, the convertible index gained approximately 10%.