Why Convertible Bonds could pay rich rewards
With US interest rates bound to rise at some point, and the EU implementing new regulations, this 150-year-old asset class offers investors an opportunity to diversify portfolios and improve risk-adjusted returns.
Convertible bond holdings offer the following:
- Opportunity to enhance risk-adjusted returns
- Portfolio diversification
- Cushion against rising rates
- Exposure to growth stocks
- Compatibility with Solvency II and IORP requirements
Equity-like returns, bond-type volatility
Convertible bonds are a well-kept secret. This often-overlooked asset class offers equity-like potential for capital gains, together with the downside protection associated with bonds. Convertibles can also add significant diversification to a portfolio. Historically, they have outperformed bonds and equities over the long term, often cushioning losses when markets fall.
As European insurers and pension funds become confronted with the EU’s Solvency II and IORP II directives, and continue to assess the efficiency of their portfolios, we expect the idiosyncratic performance characteristics of convertibles to become better understood. Moreover, with rising US interest rates and low yields causing uncertainty in financial markets, convertible bonds’ specific performance characteristics are especially relevant.
Capturing upside, limiting downside
Convertibles are designed to provide issuers with an attractive way to finance growth, and to give investors a lower-risk way to participate. Originally used to finance the high-risk US railroad industry in the 1860s, companies were able to borrow money fairly cheaply at the outset, in exchange for giving the bondholder an option to convert the bond into equity. This enables investors to participate in a company’s growth, while giving them protection if those growth plans do not materialize.
Valuable portfolio diversification
Convertible bonds’ potential for diversification arises from their hybrid structure. As bonds with embedded equity options, they can be converted to a predetermined number of shares of the issuer’s common stock if the bondholder chooses. Like normal bonds, they pay investors interest at a fixed coupon rate, and can be redeemed at face value at maturity if not converted or sold beforehand.
Why not simply hold a mixture of bonds and equities instead? Because the option to convert into equity means that convertibles can have the best of both worlds – they track equity prices higher but are protected on the downside by their bond components. This so-called convexity increases the potential for diversification. In rocky markets, the bond value acts as a floor, limiting the downside risk. What's more, because convertible bonds are tied to shares of common stock, they have proven less vulnerable than traditional bonds when interest rates rise.
Historically a cushion against rising rates
Convertibles’ embedded equity options have tended to offer protection when interest rates rise, as it may still be the case in the US. Equities have often increased in value during times of rising rates, and convertible securities have historically followed them higher. Some convertibles, however, have characteristics that make them more like fixed-income securities. These bonds can be negatively affected by rising interest rates.
The figure below highlights the performance of bond, equity and convertible indices in the periods over the past 20 years, during which the 10-year US Treasury bond yield has risen more than 100 basis points. In these periods, convertible returns have tended to reflect those of equities rather than bonds.
Historical convertibles performance during rising rate environments
Tapping into a growth company universe
Today, the universe of large global convertible bond issues is about $300 billion in size, comprising about 800 issues. The vast majority of convertibles originate from the US and Europe, with the balance from Asia including Japan. Issuing companies range from household names such as Siemens, Vodafone, and Intel, to high-growth mid-cap companies. To varying degrees, they tend to have “growth” characteristics. As shown below, the universe is broad, in terms of geography as well as credit ratings.
Breakdown of the convertible bonds investible universe
How might convertible bonds benefit your portfolio?
A possible rise in US rates and changing European regulations are making diversification and the efficient allocation of capital more important. With that in mind, convertibles have a place in institutional portfolios. Combining the growth potential of equities and capital preservation qualities of bonds, they can enhance portfolios’ risk-adjusted returns. Moreover, at a time when there are concerns that the credit cycle might be turning, it is also worth noting that convertibles have less credit risk than equities, generally ranking pari-passu with unsecured corporate bonds.
Convertibles’ asymmetric profile combines the best of equities and bonds, making them an ideal long-term diversification tool with particular strengths in uncertain markets.
Our investment team and philosophy
At NN Investment Partners, our investment team combines the skills of both bond and equity investing. We invest selectively, seeking to build a portfolio of convertible bonds that combines strong creditworthiness with participation in the equity upside.
Our investment approach emphasizes growth themes that identify and embody secular trends supporting earnings expansion. By grouping investments according to themes rather than sectors, we are able to express our top-down views more accurately than through a traditional sectoral approach, as sectors often have a very dispersed set of return drivers. We believe that themes show what is driving companies’ growth in a constantly changing world.
The convertibles universe is also broad in terms of growth themes, including healthcare spending, online spending and cloud computing. The below figure illustrates the active themes we are invested in at the moment.
NN IP Convertible strategy themes
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NN Investment Partners
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