With generally higher yields than stocks and low correlations to interest-rate-sensitive fixed income sectors, convertible securities have become a powerful tool for investors seeking growth, income and diversification in today’s market environment.
For those who may be new to this hybrid security or are looking for a refresher, here is a closer look at convertible securities.
What are convertible securities?
Convertible securities are corporate bonds with an embedded option that allows investors to convert bonds into common stock of the issuing company—which is why they’re referred to as hybrid securities.
As the price of underlying stocks gets closer to or above the conversion price, the value of the convertible bond rises, becoming more sensitive to the change of the stock price and taking on more stock-like characteristics. When the stock price falls below the conversion price, the convertible behaves more like a bond, and its value does not fall as much as the stock because the coupon and principal value of the bond creates investment value.
This unique mechanism, illustrated below, allows convertibles to offer a potential cushion in stormy markets due to the bond-like floor, while also allowing investors the possibility to capture equity-like upside potential.
Source: State Street Global Advisors. This chart is for illustrative purposes only.
Why own convertible securities?
The hybrid nature of convertibles can support a range of asset allocation goals. Here are four examples, based on historical data:
1. Growth equity exposure for upside potential: The option to convert to equities allows investors to participate in some of the upside of a rising equity market. Given that convertible financing is particularly attractive for growth companies, which tend to exhibit strong earnings and sales growth but with low cash flows, convertibles often provide growth-oriented exposure, as shown below.
2. Higher yield than equities: Because of the value of the option to convert, the yield of convertibles is usually lower than that of non-convertible corporate bonds from the same issuer. However, the chart below shows that in the past 10 years, convertibles have provided a higher yield than either equities or the traditional core fixed income segment, as represented by the Bloomberg Barclays US Aggregate Index.
Source: Bloomberg Finance L.P., as of 12/31/2018. *Dividend yield is used for the S&P 500 Index. Yield to Worst is used for the fixed income indices. Past performance is not a guarantee of future results. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index performance is not meant to represent the performance of any particular exchange traded funds. It is not possible to invest in an index.
3. Lower volatility and less drawdown than equities: Convertibles’ periodic fixed coupon payment and the return of the principal value at maturity (if not converted before maturity) can potentially provide downside risk mitigation that is absent in equities. As shown below, convertibles have experienced lower volatility and less drawdown than the broader equity market over the past 10 years.
Source: FactSet, as of 12/31/2018. Past performance is not a guarantee of future results. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index performance is not meant to represent the performance of any particular exchange traded funds. It is not possible to invest in an index.
4. Low correlation to interest-rate-sensitive fixed income sectors: With their unique risk/reward profile, convertibles have historically exhibited low correlations to traditional interest-rate-sensitive bond sectors, making them a potential portfolio diversifier. The illustration below shows how adding convertibles to a fixed income and equity asset allocation may potentially improve portfolio returns without increasing risk.
Source: State Street Global Advisors, for illustrative purposes. The global portfolio consists of Non-US Equity as represented by the MSCI ACWI ex USA Index, US Equity as represented by the Russell 3000 Index, Global Bonds as represented by the Bloomberg Barclays Global Aggregate Bond Index, US High Yield as represented by the Bloomberg Barclays US Corporate High Yield Bond Index and cash as represented by Citigroup 3-Month US Treasury Bill Index. Convertibles are represented by BofA Merrill Lynch All Convertibles-All Qualities Index. Historical standard deviation, returns and correlations of indexes are used to generate efficient frontiers. Past performance is not a guarantee of future results. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index performance is not meant to represent the performance of any particular exchange traded funds. It is not possible to invest in an index.
Due to their hybrid nature, convertibles exhibited risks commonly associated with traditional corporate bonds, as well as equity risk. The table below shows key risks of investing in convertible securities:
|Unrated Risk||A large portion of the convertibles market remains unrated because bond rating programs can be expensive and time-consuming for companies accustomed to raising capital through equity.|
|Credit Risk||There is a risk of the issuer not being able to make scheduled principal or interest payments.|
|Interest Rate Risk||As with traditional bonds, convertibles’ prices may be negatively impacted by rising interest rates, especially when convertibles trade out-of-the-money.|
|Liquidity Risk||Convertibles can be less liquid than corporate bonds, especially in times of market stress.|
|Equity Risk||The equity price may never reach the conversion price, thereby negating the value of the option to convert.|
For investors seeking exposure to this asset class, the SPDR® Barclays Convertible Securities ETF (CWB) is a compelling vehicle to access this traditionally illiquid market in a cost-efficient way. CWB is the oldest and largest US-listed convertible securities ETF with $3.8 billion in assets and has a gross expense ratio of 0.4%, 64% lower than the average expense ratio in the Morningstar Convertibles category.1
1Morningstar, as of 12/31/2018.
At the Money, or In the Money
A term in options trading to describe when an options contract is worth exercising. Call options are “at the money” when the strike price is below the market value of the underlying asset, and put options are “at the money” when the strike price is above the market value of the underlying asset.
Bloomberg Barclays Global Aggregate Bond Index
A benchmark that provides a broad-based measure of the global investment-grade fixed income markets. The three major components of this index are the US Aggregate, the Pan-European Aggregate, and the Asian-Pacific Aggregate Indices. The index also includes Eurodollar and Euro-Yen corporate bonds, Canadian government, agency and corporate securities, and USD investment-grade 144A securities.
Bloomberg Barclays US Aggregate Bond Index (the Agg)
A market-weighted index, meaning the securities in the index are weighted according to the market size of each bond type. Most US traded investment grade bonds are represented. Municipal bonds and Treasury Inflation-Protected securities are excluded, due to tax treatment issues. The index includes Treasury, Government agency bonds, Mortgage-backed bonds, Corporate bonds and a small amount of foreign bonds traded in the US.
Bloomberg Barclays US Convertible Bond >$500MM Index
A benchmark designed to represent the market of US convertible securities, such as convertible bonds, with outstanding issue sizes greater than $500 million.
Bloomberg Barclays US Corporate High Yield Bond Index
An index designed to measure the USD-denominated, high yield, fixed-rate corporate bond market.
BofA Merrill Lynch All Convertibles-All Qualities Index
An index designed to track the performance of convertible bonds.
Citigroup 3-Month US Treasury Bill Index
The index is an unmanaged index representing monthly return equivalents of yield averages of the last 3 month Treasury Bill issues.
The dividend yield is the ratio of a company's annual dividend compared to its share price.
MSCI ACWI ex USA Index
The Morgan Stanley Capital International All Country World Index Ex-USA is designed to capture large and mid cap representation across developed and emerging markets throughout the world (excluding the US).
Out of the Money
A term used to describe a call option with a strike price that is higher than the market price of the underlying asset, or, alternatively, a put option with a strike price that is lower than the market price of the underlying asset. An out of the money option has no intrinsic value, but only possesses extrinsic or time value.
A bond's principal is the amount of money the issuer of the bond owes to the bondholder in full upon the bond's maturity.
Russell 3000 Index
A capitalization-weighted equities benchmark that is designed to be reflect the entire US stock market. The index measures performance of the 3,000 US public companies and represents about 98% of the market cap of US stocks. It is a composite index that combines the Russell 1000® Index of large-cap US stocks as well as the Russell 2000® Index of small-cap US stocks.
A statistical measure of volatility that quantifies the historical dispersion of a security, fund or index around an average. Investors use standard deviation to measure expected risk or volatility, and a higher standard deviation means the security has tended to show higher volatility or price swings in the past. As an example, for a normally distributed return series, about two-thirds of the time returns will be within 1 standard deviation of the average return.
S&P MidCap 400 Growth Index
An index designed to measure growth stocks using three factors: sales growth, the ratio of earnings change to price and momentum. Constituents are drawn from the S&P MidCap 400.
S&P MidCap 400 Value Index
An index designed to measure value stocks using three factors: the ratios of book value, earnings and sales to price. Constituents are drawn from the S&P MidCap 400.
S&P SmallCap 600 Growth Index
An index designed to measure growth stocks using three factors: sales growth, the ratio of earnings change to price and momentum. Constituents are drawn from the S&P 600.
S&P SmallCap 600 Value Index
An index designed to measure value stocks using three factors: the ratios of book value, earnings and sales to price. Constituents are drawn from the S&P SmallCap 600.
S&P 500 Growth Index
An index designed to measures growth stocks using three factors: sales growth, the ratio of earnings change to price and momentum. Constituents are drawn from the S&P 500.
S&P 500 Index
The S&P 500, or the Standard & Poor's 500, is an index based on the market capitalizations of 500 large companies having common stock listed on the NYSE or NASDAQ. The S&P 500 index components and their weightings are determined by S&P Dow Jones Indices.
Yield to Worst
The lowest potential yield that investors can expect when investing in a callable bond without the issuer defaulting.