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At the end of 2022, the size of the U.S. bond market was a staggering $51 trillion, according to the World Economic Forum (WEF).
The majority of the domestic bond market is attributable to debt issued by the federal government (Treasurys), but as advisors know, corporates and munis also represent significant chunks of the U.S. bond market. Within the corporate bond space, there are convertible bonds -- a small, unheralded, but potent fixed income genre.
How small is the convertible market? Consider the following. Last year, issuance of such debt was $52 billion, or less than 10% of the interest Uncle Sam paid on Treasurys. Convertibles are known as hybrid securities, meaning they display both equity and fixed income trait. Equity traits are derived from the fact convertibles can be converted into shares of the issuer’s stocks. The debt part is self-explanatory.
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. Despite the advantages associated with convertibles, the asset class doesn’t get nearly as much attention as lauded upon traditional corporate bonds. Arguably, that shouldn’t be the case.
Assessing Convertible Perks
Historically, convertibles outperform other bonds when interesting rates rise. Emphasis on “outperform” because in this case, it should not imply positive returns. Over the past three years, the SPDR Bloomberg Convertible Securities ETF (NYSEARCA: CWB), the largest exchange traded fund dedicated to these bonds, fell 7.2%, but that was better than the 9.1% lost by the Bloomberg U.S. Aggregate Bond Index.
By now means was that a great showing for CWB, but it does highlight some of the advantages associated with convertible bonds.
“The unique feature of convertible bonds (or simply convertibles) is their distinct reaction to market conditions, compared to equity or bond investments. While no investment is risk-free, this allows convertibles to provide some protection in declining markets while also offering participation in upward-trending markets,” according to Schroders.
Another benefit of convertibles is that due to their equity traits, the bond price often follows the issuer’s share price higher. Of course, that means when the stock price falls, so do the convertbiles, but the bond’s usually decline less than the issuer’s shares.
“Furthermore, as most convertibles are senior unsecured securities, they rank higher in the capital structure than other bonds and equity,” adds Schroders. “This means that in the event of liquidation, convertible holders are paid before those holding securities lower in the capital structure, offering an additional layer of capital protection.”
Offense and Defense
Many clients believe that assets are either defensive or help them play offense and gaining exposure to both under one roof is difficult, if not impossible. It’s on advisors to alter that thinking and convertibles are an excellent place to start, particularly for income-oriented clients.
“As such, they are a real alternative for anyone who is interested in gaining exposure to the growth potential of equities but with a more defensive view and the bonus of interest payments. Convertible bonds could offer an attractive anchor in your portfolio,” concludes Schroders.
Related: Dividend Growth Stocks Prove Inflation-Fighting Mettle