This is prompting many advisers and asset allocators to re-acquaint themselves with the asset class. So what role could they play in portfolios today?
At its essence, a convertible bond is one that can be converted into a predetermined amount of the company’s equity at specific points during its life. They are often described as having the downside protection of a corporate bond coupled with the upside option of the underlying equity.
Allocating to a convertible bond fund is often considered as part of a diversified fixed income allocation. Their equity component and generally shorter duration compared with many corporate bonds means convertible bond funds can offer investors valuable protection during an inflationary, rising rate environment.
Half-way house
The exposure to equity by investing in a convertible bond fund offers upside participation in rising equity markets, while still allowing an investor to maintain value during periods of increased volatility. Although convertible bonds are certainly affected by rising interest rates, the equity component tends to dampen the negative effect of rising rates.
This was seen in the last major inflationary period between 1978 and 1982. During this period, the annualised level of inflation was 9.8%, compared to the annual average of 2.94% over the last 30 years. In this timeframe, convertible bonds dramatically outperformed treasuries and corporate bonds, but also posted equal or superior performance to equity indices. Most importantly, not only did convertible bonds post a positive nominal performance, they actually outpaced inflation to provide positive real returns.
The fact that convertible bonds have historically been correlated more closely with equity returns than any fixed income asset type means they offer investors a way to diversify fixed income allocations. While past performance should not be seen as a guide to the future, historical returns for convertible bonds have shown that approximately 50% of the returns are driven by the equity markets, 30% by movements in the credit markets, and 20% from factors specific to the convertible bond market.
Investors who are restricted in their equity holdings would be particular beneficiaries of this diversification, as their overall fixed income portfolio risk would be reduced.
Duration play
Convertible bonds are also shorter in duration compared to corporate bonds, providing additional protection during periods of rising interest rates. The typical maturity for a convertible bond is five to seven years, and they sometimes have a maturity of three years or less. Most corporate bonds hover at around eight to ten years in duration. In addition, convertible bonds frequently contain puts at even shorter intervals. This allows for early optional repayment, which is a valuable trait for a bond in a rising rate environment.
Convertible bonds are currently reasonably priced from a historical perspective and with equity markets likely to improve, convertible bond funds are expected to provide robust returns in 2013.
With investors having to dig deeper to find yield in the current market, diversifying their fixed income allocation to convertibles offers the opportunity to benefit from future rises in the equity markets but also maintain value during periods of increased volatility.
