As Rates Rise, Call on Convertibles

Ten-year Treasury yields recently stabilized, but amid chatter that the Federal Reserve is preparing to sell the corporate bond exchange traded funds it purchased as part of its pandemic-induced buying spree, some market observers are concerned another taper tantrum will come to pass.

Remember that during the infamous 2013 taper tantrum, 10-year yields resided at 1.9% on May 23 – the day then Federal Reserve Chairman Ben Bernanke indicated the central bank would pause its bond buying. By September 2013, 10-year yields were at 2.9%.

That doesn't mean history will repeat this year, but for advisors, it still pays to discuss rising rates protections strategies with clients. As I noted a few weeks ago, convertible bonds historically perform well when rates rise.

As I noted at the time: “Advisors looking for an effective way of explaining convertibles to clients highlight the hybrid nature of these bonds – they've got equity and fixed income traits – and lean on the name. Put simply, convertibles are bonds that can later be converted by the bondholder into share of the issuer's equity.”

Making the Convertible Call Today

Admittedly, some of the blush has come off the convertible rose as the Bloomberg Barclays U.S. Convertible Liquid Bond Index is off 9.55% from its February high. Obviously, that's nothing to write home about, but that mini-slump could present advisors with reason to revisit convertibles. In fact, a wave of convertible issuance amid the coronavirus pandemic could serve to generate new found buzz in this smaller corner of the bond market.

“The COVID-19 pandemic unleashed a wave of new convertible issuance, as many companies sought capital to shore up balance sheets in the difficult early months of lockdowns and restricted travel,” writes Inveco analyst Stuar Novick. “In fact, record-setting issuance of $106 billion in the US convert market last year, in addition to the strong performance of the asset class, propelled the size of the asset class from roughly $200 billion in market value at the end of 2018 to a more recent $361 billion, according to data from Bank of America.”

Thing about convertibles, regardless of interest rate action, is that this form of corporate debt potentially offers more perks than traditional investment-grade and junk corporates.

“For bond-focused portfolios, converts can provide price appreciation through their embedded equity call options,” adds Novick. “Furthermore, according to data from Bank of America, convertibles have posted a long-term cumulative return well in excess of high yield bonds as well as investment-grade corporate and government bonds.”

Translation: Advisors may find that convertibles are compelling to younger, more risk-tolerant clients that want significant equity allocations and are questioning the wisdom of standard fixed income exposure in today's trying bond climate. For those clients, convertibles check the fixed income box while levering them to equity market upside.

Back to Rising Rates

Owing to the asset class's rising rates reputation, convertibles are a potential consideration for a wider audience of clients beyond the aforementioned. In fact, the possibility that rates may rise further is a credible invitation to bring convertibles to light in client conversations.

“Another important attribute of converts has been their performance during periods of rising interest rates,” says Invesco's Novick. “In fact, the table below shows that in each of the last 13 periods of rising interest rates in the US going back to 1989-1990, the performance of convertibles, as measured by the ICE BofA US Convertible Index, has exceeded that of US government bonds (as measured by the Bloomberg Barclays US Government/Credit Index). Converts also outpaced the returns of the high yield market in a majority of those timeframes, as measured by the Bloomberg Barclays US Corporate High Yield Index, and they even outperformed the S&P 500 Index during several of those periods.”

Bottom line: 2021 is presenting advisors with more fixed income difficulty than they likely anticipated at the start of the year. Convertibles can ease that burden and do so across wide array of client portfolios.

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