Understanding Intricacies of Convertible Bonds

Broadly speaking, bonds are performing better than they did last year, but that’s not saying much as the Bloomberg US Aggregate Bond Index is higher by just 0.3% year-to-date.

However, there are some corners of the bond market that are standing out, including convertibles. 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.

Convertibles are known as hybrid securities, meaning they display both equity and fixed income traits – the former explaining the asset class’s impressive performance this year. The SPDR Bloomberg Convertible Securities ETF (NYSEARCA: CWB), the largest exchange traded fund dedicated to these bonds, is up nearly 8% this year.

For advisors, convertibles’ correlations to stocks are easy explained to clients. These are corporate bonds with options allowing bondholders to convert that debt shares of common stock of the issuer. The number of shares that can be converted is set when the bonds are issued.

Convertible Plumbing Matters

While convertibles can be alluring for aggressive, risk-tolerant bond investors, education is needed for clients that aren’t familiar with this corner of the bond market. After all, this isn’t the standard form of corporate debt they’re accustomed, meaning understanding the inner workings of convertibles is essential.

With convertible bonds, “as the stock price gets closer to or above the conversion price, the value of the convertible bond typically rises, becoming more sensitive to the change of the underlying stock price (high delta) and taking on more stock-like characteristics,” notes State Street Global Advisors (SSGA). “On the other hand, when the stock price falls below the conversion price, the convertible behaves more like a bond, and its value typically does not fall as much as the stock because the coupon and principal value of the bond create investment value (bond floor).”

From a return perspective, historical data indicate convertibles stack up well when measured stocks across style factors and market capitalization ranges.

“The option to convert to equities allows investors to participate in some of the upside of rising equity market,” adds SSGA. “And given that convertible financing is particularly attractive for growth companies, which tend to exhibit strong earnings and sales growth but with low cash flows, convertible bonds often provide growth-oriented exposure.”

Convertibles Income Proposition

Due to the upside potential/equity traits associated with convertibles, these bonds will typically sport lower yields than standard corporate debt, even investment-grade fare.

However, the aforementioned CWB sports a yield of 1.83%, which is almost 25 basis points in excess of the S&P 500’s dividend yield. There are other convertible benefits worth highlighting, too.

“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,” concludes SSGA. “Convertibles have experienced lower volatility and typically lower drawdown than the broader equity market over the past 15 years. And, in the event of default, convertible bondholders are paid out before common stockholders.”

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