Understanding Convertible Bonds

The convertible bond market is practically an asset class all to itself because of the hybrid nature of these instruments. A convertible bond is essentially a bond issued by a corporation that allows holder to convert the bond to stock based on a predetermined formula. This is typically an option and not a requirement. So in a sense, you as the investor have the benefit of both a stock and a bond holding. Most convertibles will be issued with a maturity of at least 10 years. In most cases the coupon (interest rate) is issued at a lower rate than non-convertible issues by the same corporation.

The biggest benefit to the issuer/corporation is the lower interest payment on its debt obligation. Should the bond get converted by the holder, the debt of the company disappears, but at the cost of dilution to existing shareholders.

The benefit to the holder of the bond is they can simply hold the issue to maturity/callable date with a guaranteed rate of return like any other corporate note, with only the credit quality of the underlying issue to be concerned about. Should the pre-determined conversion price be appealing, the holder can benefit from participation in the stock price appreciation through the conversion. Additionally, while the average maturity is more than 10 years at issuance, the conversion and callable features they are typically issued with actually lowers the average duration of a fairly well diversified convertible fixed-income portfolio.

In terms of buying fixed-income in general, the majority of investors would be better suited to diversify their fixed income holdings through bond funds and ETFs. This is primarily related to the pricing mechanisms of how bonds are traded on a negotiated basis. Most often the average investor will not see the same price for a fixed income issue that an institutional portfolio manager will receive.

Particularly in the case of convertible securities which can be far more complex than a traditional bond, a diversified portfolio manager or ETF is more appropriate. In the case of convertibles there are three basic characteristics that must be monitored. They are:

  • Conversion Price…The price paid to acquire the common stock.
  • Conversion Ratio…This determines the number of shares of stock the bond holder would receive.
  • Conversion Premium…This determines the premium paid between the conversion price and the current market value of the underlying security.

In terms of risk and volatility, it should be noted that because of the conversion feature of these bonds, they more often tend to correlate to price movements in the stock market, rather than correlating with the rest of the investment-grade fixed-income market which is more sensitive to interest rate changes. So as an investor, when you buy a convertible bond fund or an ETF, be prepared for the volatility.

In general they tend to be less volatile than most stock funds with returns that are not that far from stock market like investment returns. However, if you are looking to balance risk with other stock-based investments, convertibles will more likely increase your portfolios correlation and do little to reduce volatility if treated as a fixed income holding. For this reason you may want to allocate convertible securities in your portfolio as part of their equity exposure. However, when we are completing an analysis of an investment allocation… it may seem that a portfolio is weighted more towards fixed income than its stated target. In reality, it is a means to capture equity-market like returns with less volatility.

As an example, recent 10-year performance data reflects that the total US Stock Market Index is up 7.47% through Nov 30-2015. The Barclays US Bond Index is up 4.49% over the same period. Yet the Barclays US Convertible bond market index is up 6.40% over the same period.

What about volatility?…During the 2008 market crisis the total US stock market declined for the year approximately -37%. Conversely the convertible securities market fell by -29%. This is illustrative of equity-like returns with less price volatility.

As mentioned earlier, in most cases due to the way in which fixed-income is priced, many investors may be better suited to use active managers in the fixed-income markets. However, as convertibles tend to have more equity-like characteristics, returns have been more favorable with the lower-cost ETF and index-fund solutions. History shows little evidence that active management has played a beneficial role in this asset class when compared to the benchmark.

When evaluating convertibles and the role they may play in your investment portfolio, this like any other investment, should be done in the context of a larger long-term financial planning strategy. As such, it tends to be one of many different assets that comprise an overall portfolio’s construction. There is never any one asset class that can, or should, completely dominate an investment plan for any investor who wishes to take a strategic approach to financial planning. Hence it is prudent to limit exposure to these types of securities as it is for all asset classes.

As always, it’s important to remember that each investor’s circumstance is unique and should be addressed accordingly.