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Rising interest rates are wreaking havoc on the bond market this year. That’s one of the many reasons clients need advisors. After all, it’s an advisors job to know that while the Federal Reserve is tightening rates, not all corners of the bond market are lost causes.
In fact, some fixed income segments have track records of proving durable as rates rise. A prime example is convertible debt. Convertibles, like some other bonds, are considered hybrid securities, meaning they display traits of both bonds and stocks.
That’s particularly true with convertible debt because, as the name implies, these bonds can later be converted into common equity of the issuing company. Knowing that stocks often hold up surprisingly well as rates climb, it’s not surprising that convertibles do the same. Bank of America recently highlighted the benefits of convertibles against the backdrop of the Fed’s newest tightening cycle.
“We reiterate our Favorable View of convertible bond ETFs. Convertible bonds can be thought of as a traditional bond with the option to convert holdings into common stock at the holder’s choice. This structure combines equity beta with meaningful yield,” say the BofA analysts in a recent note.
Growth and Income
Relative to other bonds, convertibles can be more attractive on the basis that clients can gain access to elevated income profiles and potential for superior capital appreciation – a coveted combination to be sure.
“The market has always attracted smaller-cap, higher-growth issuers as converts provide this type of borrower unique benefits, including a lower interest expense than traditional bonds, delayed equity dilution, an avenue to monetize potential equity upside and volatility, and relatively few restrictive covenants,” notes Bank of America. “These features help explain why converts have historically been more-correlated to the NASDAQ and Russell 2000 than they've been to the S&P 500.”
Adding to the allure of convertible is that these bonds offer compelling risk-adjusted returns and, in many cases, outperform the stocks of their issuers. Those are vital facts many clients aren’t aware of.
“The hallmark benefit of convertible bonds is an asymmetric risk profile. Their unique, hybrid structure provides investors exposure to the issuer's common equity while also providing a downside support via a bond floor,” adds BofA. “This feature, referred to as positive convexity, can ultimately dampen a convertible's volatility and improve risk-adjusted performance, especially compared to the issuer's underlying stock.”
Convertibles: Because Rates Matter
As noted above, one of the primary reasons to consider convertible bonds today is rising interest rates. Of course, it pays to have credible information on that front to supply to clients.
“Convertible bonds are also attractive relative to fixed income peers. In addition to attractive yield and equity beta, converts’ equity exposure allow them to be less rate-sensitive than their traditional fixed income counterparts. US converts have an average effective duration of just 1.9, well below that of HY, IG, and government bonds,” concludes BofA. “This offers a key benefit to fixed income investors in an environment of rising yields, in our view. We prefer investments with lower interest rate risk (duration) and higher credit risk given resilient fundamentals.”
Advisors looking to simplify things with convertibles may want to consider exchange traded funds, of which there are several from well-known issuers dedicated to this asset class.
Related: Preferred Stocks Are Pertinent Again