It might be time to take a ride in convertibles
The convertible bond market grew about 36% in total between the end of 2019 and the end of March 2022, according to data from the global research team at Bank of America Merrill Lynch and Jefferies Group LLC.
Additionally, data from BofA and Jefferies revealed that global convertible bond issuance averaged around $80.5 billion per year during the five-year period ending in 2019.
And with higher levels of volatility, “the optional component of convertible bonds increases in value,” Miller noted. Additionally, convertible bonds tend to have less interest rate risk than investment grade or high yield bonds because “the embedded option increases in value as interest rates rise”, Mr. Miller added.
“With inflation, for example, there has historically been a strong correlation of rising interest rates in inflationary environments, as the Federal Reserve attempts to bring inflation back to its 2% target,” he said. said Mr. Miller.
“Historically, going back to January 1977, when inflation averaged above 2% for a month, the average 10-year U.S. Treasury yield was 7.1%, and when inflation averaged below at 2% per month, the 10-year US Treasury yield was 3.2%.
During periods when inflation pushed rates higher, Miller noted, traditional bonds suffered losses, but convertibles weren’t hit as hard.
Convertible bonds have historically been “less volatile than stocks during periods of high inflation,” Miller said.
On a relative basis, said Advent’s Maitland, convertibles look attractive relative to core fixed income because of the equity conversion option as well as their more attractive current yield. As of April 30, Maitland said, convertible bonds represented by the ICE BofA All US Convertibles Index had a yield of 1.9%, compared to a 2.6% yield for the Bloomberg US Aggregate Bond Index. But the duration to April 30 for convertibles was just 2.1 years, compared to 6.5 years for core fixed income, limiting the downside risk of convertible bonds, he said.
Additionally, relative to other fixed income asset classes such as high yield loans and bank loans, convertibles have experienced “significantly lower default rates historically, higher risk-adjusted returns over the 10 years and significant outperformance in periods of rising interest rates”. rates.”
Advent has $10 billion in assets under management.
Mr Maitland said that in the 11 periods since 1992 when the 10-year Treasury yield rose at least 100 basis points, convertible bonds generated an annualized total return of 20.14%, while that 10-year Treasury bonds returned -7.75%; high yield companies gained 10.89%; bank loans increased by 7.43%; and high quality companies edged up 0.3%.
Depending on the underlying conversion price, convertible bonds can trade with “significantly less sensitivity” to inflation and interest rates than traditional non-convertible bonds, said George J. Cipolloni III, manager of Philadelphia-based portfolio at fixed-income specialist Penn Mutual. Asset Management, which has $33.6 billion in assets under management.
Some pension funds see the benefit of adding convertible bonds to their asset mix. For example, the $84.6 billion New York City Employees Retirement System and the $51.7 billion New York City Police Pension Fund both have a bond allocation. convertibles, said Michael Haddad, acting chief investment officer of the Bureau of Asset Management, which oversees the investment. portfolio for each of New York City Retirement Systems’ five pension funds, which had total assets of $263.2 billion as of March 31.
“Convertible bonds can be attractive in a rising rate environment because the interest payments associated with convertible bonds provide annual income, which a public stock, depending on its dividend policy, may not,” a- he writes.
NYCERS has about $1.4 billion in convertibles and the police plan has $1 billion, which equates to allocations of 1.6% and 1.9%, respectively.