Not to sound crass, but the pandemic has been very good to the convertible bond market. The economic lockdown caused by Covid-19 unleashed a flood of new convertible issuance by companies in need of rescue finance, and that has acted like a booster rocket for this asset class and helped propel roughly $90 billion in issuance of convertible securities during the first half of 2020—a nearly 50% increase in this market’s overall size since the start of the year.

Convertible bonds are back in the limelight, and investors are taking notice of these hybrid securities with equity-like features. But that alone isn’t reason enough to invest in convertibles now. The better reason, for those who are interested, rests with the long-term track record of the asset class.

“A lot of people assume they don’t have to invest in convertibles,” says David King, senior portfolio manager and head of income and growth strategies at Columbia Threadneedle Investments, where he co-manages the Columbia Convertible Securities Fund. “I say, ‘What if I told you there’s an asset class that has performed in line with stocks with lower volatility and more current income? Wouldn’t you be interested in that asset class?’ Convertible securities have done that.”

According to Columbia Threadneedle, the ICE BofA All Convertibles-All Qualities Index produced annualized returns of 6.40% with a standard deviation of 12.44% from July 1, 2000, through June 30, 2020. In the same 20-year period, the S&P 500 scored a 5.91% return with a standard deviation of 14.97% (a lower standard deviation is better). The Bloomberg Barclays U.S. Aggregate Bond Index returned 5.14% with a standard deviation of 3.41% during that period.

Convertible securities can be either bonds or preferred stocks, but this article will focus on convertible bonds, which contain a call option that lets the holder convert them into a predetermined number of shares of the common stock of the issuing company. That option gives the securities equity-like sensitivity and lets convertibles participate in the upside when the company’s stock appreciates, while the fixed-income coupon provides some downside protection if the stock falters.

Convertible bonds often come with five-year maturities, and while they yield less than high-yield bonds and typically less than investment-grade corporate bonds, they yield more than Treasury bonds and usually more than the dividend on a company’s common stock. Investors who don’t convert them into equity collect the bond’s face value at maturity.

While the index performance numbers cited above look impressive, Columbia Threadneedle notes that the convertibles index isn’t an apples-to-apples comparison with the S&P 500’s large-cap, higher-quality, often defensive companies. Issuers of convertible bonds typically are smaller, high-growth entities that tend to be cash-poor, non-investment-grade companies. Traditionally, convertible bonds have been a popular vehicle of choice for tech and health-care companies needing to raise money to fuel their growth.

For issuers of convertible bonds, one advantage is that they have lower interest payment obligations than high-yield bonds. King says companies issue convertibles for three reasons. Younger companies can finance their growth with them. Convertibles also help companies pay for mergers and acquisitions. And in times of misfortune, the securities offer a finance channel to help companies survive. King says there wasn’t much need for such rescues during the past decade, which more or less put a lid on the growth of the convertibles market.

“There was no rescue finance because the world was steady Eddie and rates were really low,” he explains. Then, he says, “not only do we enter a recession, but it’s a very unique recession where certain parts of the economy were shut down cold. It was like, ‘Whoa, we need rescue finance.’”

He says new convertible issuance exploded in April and May, and he expects 2020 to be among the highest issuance years ever.

New Faces
What’s different this year is that certain companies are coming to the convertibles market that normally don’t play in this space. That includes businesses in the consumer discretionary sector (think: retailers), as well as the natural gas, cruise line and airline sectors. This influx has broadened the market and provided more investment opportunities.

But not all opportunities are equal.

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