When many people hear the word “convertible,” carefree driving, sunny roads and wind-blown hair probably come to mind. Franklin Equity Group Portfolio Manager Alan Muschott thinks of convertibles as something entirely different. He sees an investment vehicle, and one that doesn’t represent reckless abandon, but rather, one that can offer attractive yields to income-seeking investors as well as an asymmetric risk/reward profile. Here, he makes the case for why investors might consider convertible securities in the coming year, particularly as US interest rates look set to continue rising and many global uncertainties remain.
Those looking back at 2016 may be surprised to find a lack of volatility as markets generally took in stride both the United Kingdom’s vote to leave the European Union (known as Brexit) and the surprise election of Donald Trump as the next president of the United States. As equity markets—particularly in the United States—moved higher, global interest rates remained historically low, with negative government bond yields in Germany, Japan and Switzerland making headlines. This may change in 2017, however.
Impact of Rising Rates
Even if we do not see a general paradigm shift toward widespread rising interest rates globally, rates can rise suddenly and strongly, taking the markets by surprise. When that happens, traditional government and corporate bonds face losses, and the potential losses are typically higher for bonds with longer maturities. This risk is expressed as duration risk—the measure of a fixed income instrument’s sensitivity to changes in interest rates.
Corporate treasurers have taken the opportunity in recent months and years to refinance and increase debt loads in an environment of low interest rates. Overall, duration risk is significantly higher for conventional bonds compared to convertible bonds. Many convertibles are issued with a maturity of three to five years, either maturing as a traditional bond or converting to equity. Additionally, if the underlying equities are performing well, the associated convertible securities should trade based on their conversion value rather than their bond characteristics.
In the last few decades, there have been five periods of rising rates and corresponding negative returns for government bonds. These periods differed in length and magnitude, but they had one characteristic in common: although convertible bond performance was not always positive, convertible bonds performed relatively well compared with government bonds. (See chart below.)
In our view, 2017 could be a year where the properties of convertibles become an increasingly important feature for investors’ asset allocation. We expect to see an environment supportive of equity markets, driven by a general shift from expansive monetary policy to expansive fiscal policies—and not only in the United States. In this environment, we think a well-structured convertible bond strategy with the goal of participating in a majority of the underlying equities’ upside, and less of the underlying equities’ downside, offers investors an attractive risk-reward investment option.