Convertible Bonds: The Rodney Dangerfield of Liquid Alts
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Historical returns have been outstanding for convertible-bond strategies. Moreover, low drawdowns during bear markets give these products an attractive risk-return profile, especially when compared to other liquid alternatives.
But convertible bonds are like comedian Rodney Dangerfield: They get no respect. Convertibles are overlooked because they are hard to label and underappreciated because they are not as sexy as stocks. So convertible bonds are relegated to a supporting role in a portfolio.
But after many years of consistently strong performance, convertibles are ready for a leading role.
While attending an investment forum in Boston on September 28, I met with Greg Miller, a portfolio manager at Wellesley Investment Advisors (WIA). His firm specializes in convertible-bond funds. Miller focused on the long-term track record of WIA and its Miller Convertible Bond Fund (MCIFX).
His presentation included the returns of WIA’s separately managed account (SMA), shown in Exhibit 1. The returns have been surprisingly strong through both bull and bear markets and have had limited drawdowns during bear markets. According to Miller, the SMA has generated annual returns of 10.7% from inception in 1995 through 9/30/14 (net of fees of 0.75%). This compares to returns of 9.7% for the S&P 500. As for volatility, WIA has had a standard deviation of 8.2% since inception in 1995, while the S&P 500 has had 15.2% for the same time period.
This pattern of returns immediately struck me as extraordinary. I have been on the buy side since 1985, and I am the co-author of a book that evaluates alternative mutual funds: Alts Democratized, just released from Wiley Finance. Alts Democratized systematically reviews all 11 Lipper classifications of alternatives. Most of these products have not delivered attractive long-term returns. Moreover, most liquid alts are highly correlated to traditional asset classes (stocks, bonds, etc.) and to traditional factor exposures (value vs. growth, optionality, trend following, etc.). Consequently, most liquid alts fail to deliver on their marketing promises.
Convertible bonds from Wellesley are an outlier. WIA generated attractive returns over a full market cycle without excessive drawdowns. The reason is simple; convertibles are correlated to stocks during bull markets because of the conversion feature, but the par value of the bond provides downside protection during bear markets. After all, convertible bonds are bonds first and foremost. As long as the company remains solvent, investors get their money back.
Most convertibles also have a “put” feature that gives the owner the right to sell the bond back to the issuer and receive early payment of principal (usually par value of $1,000). The investor may have this right to put the bond on one or more dates, as specified in the prospectus. These dates may be every one, three or five years depending on the maturity date of the bond. Regardless of the details, the put feature reduces the effective duration of the bond, which mitigates both credit risk and interest rate risk.
Despite their impressive track record, convertible bonds are easy to overlook, like comedian Rodney Dangerfield, famous for his trademark line: “I don’t get no respect.” Dangerfield wrote and starred in Back to School, which was a top-10 film in 1986, but he stuck with the hapless on-stage persona.
Back to School featured Joe Pesci, who later won an Academy Award for his work in Goodfellas. Pesci won Best Actor in a Supporting Role and this may be a better a metaphor for convertibles: Character actors often deliver outstanding performances, but they rarely get a star turn.
Likewise, convertibles are not as flashy as stocks, so they often suffer in comparison. Convertibles are also hard to label, just like character actors.
Nevertheless, as demonstrated in the return data below, convertibles are ready for a leading role.