Convertible Securities: Combining the benefits of stocks and bonds

How have convertible securities performed lately and what’s the outlook?

Investors have had a difficult time finding any safe havens during this year’s sell-off in the equity and bond markets, and convertible securities have been no exception. The universe for convertible securities tends to be concentrated in the technology, health care, and consumer industries, and as a result the asset class has declined along with those equity sectors. Nevertheless, we believe convertibles  may still present opportunities for investors in the current environment for several reasons.

Outperformance during periods of rising interest rates

Historically, convertible securities have performed well during periods of rising interest rates. Due to their generally short maturities of five years or less,  as well as the inclusion of puts and calls, convertible securities tend to have shorter durations than non-convertible bonds.

The convertible universe, as measured by the  ICE BofA US Convertible Index, currently has a duration of 2.1 years.¹ For comparison, high yield has an average duration of 4.3 years (Bloomberg U.S. Corporate High Yield Total Return Index) and investment grade debt has an average duration of 6.5 years (Bloomberg U.S. Aggregate Total Return Value Unhedged Bond Index).¹ While convertibles are affected by interest-rate fluctuations just like other fixed income assets, they are also impacted by the price movements of their underlying stock – and this has tended to help in periods of rising interest rates. This is because equities historically tend to outperform traditional fixed income when rates rise.

As shown in the chart below, since December 1989, there have been 13 periods in which U.S. 10-year Treasury yields have risen more than 118 basis points (bps). During these periods, convertibles outperformed investment grade corporate and government bonds in all periods, and they even outperformed the S&P 500 Index in four of those periods. In addition, convertible securities outperformed high yield and senior loans in eight out of the past ten periods.

Convertible securities may offer upside potential with less downside vs equities

Convertibles (as represented by the ICE BofA US Convertible Index) have declined roughly -20% in 2022, far less than the -36% decline in the stocks that underlie those securities.² Convertible securities have also outperformed the NASDAQ composite and Russell 2000 indices on a year-to-date basis (-29.2% and -23.4%, respectively).³ Convertibles have essentially delivered on one of their benefits of falling less than their issuers’ common stock, due to their fixed income component.

Convertibles offer yields plus a low-cost call option

As stock prices and convertible securities prices have declined, the yields on those convertibles have increased. The average yield (yield to maturity or put) on a U.S. convertible bond has moved from 2.6%⁴ at the start of the year to most recently 5.2%⁵, according to Barclays, with approximately 40% of the convertible market now more considered “credit sensitive,” almost double the percentage from the start of the year.⁶ Credit sensitive convertibles exhibit less equity sensitivity and more bond-like characteristics such as higher yields, higher conversion premium, and less downside risk relative to the common stock.

The increase in the number of credit sensitive convertibles has attracted interest from non-traditional buyers in the asset class, as investors normally focused on non-convertible debt are finding attractive yields combined with cheap, although out of the money, imbedded call options in convertibles. Additionally, many of these non-traditional investors are attracted by the opportunity to invest in companies not typically found in the traditional fixed income space, as nearly three-quarters of companies with outstanding convertibles don’t have any non-convertible debt outstanding, according to Barclay’s data.⁷ We believe this could be supportive of the asset class going forward.

Convertibles are trading at more attractive valuations

Convertible prices have cheapened on a theoretical basis, meaning that prices have declined relative to the credit strength of the bond’s issuer and the volatility in the underlying stock. In fact, U.S. convertibles are currently undervalued, according to Bank of America (see the graph below),⁸ near the cheapest they have been since the depths of the pandemic over two years ago.

To summarize, while stocks and bonds haven’t exactly shined during this current pullback, the Invesco Convertible Securities Team sees reasons for optimism in the convertible space. These securities have historically performed well during periods of rising rates, and as of late they have performed as designed, falling far less than their underlying stocks.

Convertibles may also be supported by interest from new investors, and the market is now at its lowest valuation since the start of the pandemic, more than two years ago. And as always, the asset class can provide diversification, offering lower interest rate sensitivity versus traditional fixed income and potentially lower volatility versus equites.

The Invesco Convertible Securities team continues to focus on what we believe is the best opportunity in this market –convertibles that may offer both upside participation should their underlying stocks rise and may offer downside support via the securities’ fixed income attributes. Additionally, given the increase in the number of convertible issues now offering attractive yields, we are selectively adding credit sensitive bonds to the portfolio, which we believe may provide worthwhile returns and mitigate on the downside at lower prices.