“Just because there are new issues doesn’t mean there’s an attractive opportunity set,” says Justin Kass, co-portfolio manager of the AllianzGI Convertible Fund. The winners in this market include Tesla, a large issuer of convertibles whose stock price has zoomed, as well as companies in the software-as-a-service space that have benefited from the shift to cloud computing and whose stocks have done well. A common stock’s outperformance boosts the value of the convertibles connected to it.
Certain companies have gained from consumer trends fostered by the pandemic, and that has helped the convertibles market as well. “Covid has created some huge winners such as Zillow, Etsy and Wayfair that have benefited from massive year-over-year growth,” Kass says. “In other sectors, cruise lines are completely shut down. But if cruising does pick up, or there’s a return to the mall or more normalcy in the market, then you could see big returns from airlines or select retailers or cruise lines.”
Kass noted that the ICE BofA All Convertibles-All Qualities Index was up 15% this year through July, while the S&P 500 was just a couple of ticks above breakeven.
Three Tranches
It helps to understand the three tranches of the convertible bond market. The first are equity-like convertibles, which move more one-for-one with their affiliated common stock. Another segment comprises so-called “busted convertibles,” which trade more like fixed-income surrogates and don’t have a lot of equity sensitivity. Instead, they trade more on credit spreads and credit metrics.
The third group, which Kass says is his fund’s focus, is in the middle, in what’s called total return or balanced convertibles. “We believe that total return convertibles are the most compelling part of the market since they provide an attractive asymmetric risk/reward return profile. Total return convertibles typically capture 60% to 80% of the upside of the underlying equity while only participating in 40% to 50% of the downside. This return profile is what makes convertible bonds so attractive to investors who are looking to dampen downside volatility while seeking upside potential.”
Diversification
Convertible securities aren’t easy to access because they trade on the over-the-counter markets. That means funds specializing in this space are the way to go for most retail investors.
The hybrid nature of convertible bonds can lead to classification confusion. Morningstar puts the Columbia Convertible Securities Fund, the AllianzGI Convertible Fund and their ilk in its convertible bond fund category.
But Kass says convertibles have a higher correlation to equities. “We believe they belong in the equity side of the portfolio, but they do have those defensive fixed-income characteristics,” he says.
King notes the convertibles space typically attracts moderately conservative investors. To his thinking, the products offer such clients a powerful style diversification tool when their equity portfolios are often too heavily tilted toward value, which has underperformed growth for a long time.
“Convertibles are a growth-oriented strategy, but it has a beta lower than the S&P and with more income,” King says, adding that the yields in convertible bonds are “quite a bit higher” than they are in the Treasury market. But the correlation between convertibles and U.S. Treasurys is virtually zero, so they provide bond diversification, too.
So, is this a good time to invest in convertibles? “I think recent good performance is a bad reason to be attracted to an investment,” King wrote in a research note. But he added that he expects the robust issuance of convertible securities to continue for some time, which he believes will work to the benefit of investors.