When convertible bonds are mentioned, the reaction of most people is to yawn. They have a reputation of being a bit geeky and in the realm of mathematicians. But in a time when interest rates are starting to creep up – albeit slowly – and equities are climbing a ‘wall of worry’, the chameleon properties of convertibles mean they could be worth a second look.

A convertible bond is a fixed-rate instrument that can convert into shares at a specific share price, which is preset by the issuing company at a premium over the current share price. The bond also has a coupon, but the interest rate is lower than that of a normal bond, because the conversion feature gives it an equity upside.

So convertibles have an equity correlation and can move with the underlying share price. But they also have a ‘bond floor’ – i.e. a price below which they cannot fall (unless the company loses creditworthiness) due to the interest rate they are paying.

This hybrid bond-equity make-up can shape convertibles into a flexible and attractive vehicle to some investors. It optimally protects an investor’s initial investment on the downside, but it also lets them make the most of the upside if the company’s shares increase in value.

There are a few different types of convertible bonds:

– Some operate way below the share price at which the bond converts and will behave like regular bonds, as the equity kicker is too far away to matter

– Some have become pure equity, as the share price has risen substantially

– Others are in between and trade with a mixture of both the bond and equity factors – this is known as the ‘balanced’ zone

The graph below shows how this works.

WHAT KIND OF RETURNS DO CONVERTIBLE BONDS OFFER?

Historically, convertible bonds have returned as much as equities, but with about half the volatility. If that sounds too good to be true, there are a couple of caveats.

Interest rates and bond yields have dropped for decades, which has helped bond floors to go up.

The convertible market is also much smaller than the equity markets, so you could never replace all the shares in your portfolios with convertibles.

However, when interest rates rise and equities feel nervous about how far rates will go, convertibles have often delivered a better risk/return ratio than a simple blend of equities and fixed income. This is one of the reasons we believe they will be key in 2019.

Good convertible managers can move from one bond to another and will take advantage of market moves. The same managers can also move from one region of the world to another, or one credit rating to another, and hedge or not hedge the underlying currency of the bond. This creates a lot of variables for an active manager to play with.

AN IMPORTANT INVESTMENT THEME FOR 2019

Properly managed, convertibles can give a great risk/return ratio and improve that ratio in a diversified portfolio, making them a valuable addition while equity markets continue to climb an ever-growing wall of worry.

That leads us to ask whether convertibles are right for retail investors. Convertible bonds are a specialist asset class and are deemed to be fairly complex.

One disadvantage of convertible bonds is that the issuing company has the right to call the bonds, meaning the company can convert them from equities back into bonds. This might happen when the stock’s price goes higher than the amount investors can redeem the bond.

Another issue is that they are relatively illiquid, meaning investors can’t realise their investment particularly quickly. 

Using the services of a fund manager may therefore be a better way for retail investors to access these products.

WHAT FUNDS CAN RETAIL INVESTORS USE TO ACCESS CONVERTIBLE BONDS?

Retail investment funds that play the convertible bond theme are relatively few and far between, but there are a few that have historically invested in convertible bonds.

For example, Jupiter Dynamic Bond Fund (B7NFPD8) is one of the biggest retail bond funds in the UK, investing in different parts of the bond market. It is managed by Ariel Bezalel, supported by Jupiter’s team of fixed income specialists.

Another one is Aviva Global Convertibles Fund (B86L3G9) which is a balanced fund, with fairly equal exposure to the US, Europe and Asia including Japan, with a delta (correlation to equities) of slightly above 50% and a 25% exposure to the IT sector with an average investment grade rating and a focus on balanced convertible bonds.

These are examples rather than fund recommendations and DIY investors should always do their own research before making an investment decisions.

‹ Previous2019-01-17Next ›