This article was written by Stuart Novick, a Senior Analyst working with the Invesco Convertible Securities team.
As investors anticipate rising rates, we examine the historical performance of convertible securities.
Over the past few months, several major companies involved in the automotive, telecommunications, energy and other industries have issued convertible securities to help fund their business activities. Some investors may not be familiar with convertibles — but given their historical outperformance during times of rising interest rates, I believe now is the time for investors to peer under the hood and learn how convertibles work.
What are convertibles?
A convertible bond is a corporate bond that has the added feature of being converted into a fixed number of shares of common stock. They make up a small, but important, part of the capital markets.
The asset class weighs in with a market value of about $207 billion in the US, which is considerably smaller than the $1.35 trillion domestic high yield market.1 Yet convertible securities provide an important source of financing for companies. They are particularly used in the speculative corners of the technology and health care sectors, but they also provide funds for large-cap, “mainstream” corporations seeking to finance merger and acquisition activity, repay higher-cost debt obligations, or utilize for general corporate purposes.
Why consider convertibles?
The unique structure of convertible securities combines equity and bond features. Therefore, they can provide a measure of risk mitigation in equity-oriented portfolios due to their bond-like regular coupons and stated maturities, as well as their capital structure seniority relative to equities. For bond-focused portfolios, converts can provide the potential for price appreciation through their embedded equity call options.
What makes convertibles especially attractive today, in my view, is their historical performance during periods of rising interest rates. In fact, the table below shows that:
- In each of the last 10 periods of rising interest rates in the US going back to 1989-1990, the performance of convertibles has exceeded that of US government bonds.
- Converts also outpaced the returns of the high yield market in a majority of those timeframes.
- They even outperformed the S&P 500 Index during almost half of those periods.
Thus, investors seeking an alternative to traditional fixed income in a rising rate environment may want to consider converts given their history of outperformance in those periods.
What drives convertible performance?
There are several reasons behind these results.
- Unlike non-convertible corporate or government debt, convertibles contain an equity component (usually a call option on the issuer’s stock) so that total returns are generated by their bond components (i.e., coupon, maturity, the perceived financial strength of the issuer and the level of seniority the security holds in the issuer’s capital structure) and their stock-like features as well.
- Many converts are issued by companies in growth-type sectors such as technology, which are more likely to perform better during periods of economic expansion (when interest rates are most likely to rise).
- Convertibles also tend to have shorter durations than non-convertible debt,2 mitigating the impact of rising interest rates on their valuations. That’s due to converts’ relatively short maturities (many are issued with five-year maturities) in addition to the imbedded put and call options in many convertible bonds, which effectively shorten the time they remain outstanding.
Talk to your advisor