Convertible Securities: a Versatile Asset Class

Rising interest rates and volatile markets can create headwinds for all types of investors. Franklin Equity Group’s Alan Muschott makes a case for convertible securities, a hybrid asset class that he thinks can adapt to various market conditions.

Amid expectations that US interest rate increases could accelerate, many fixed income investors in particular have asked for our view on the prospects for convertible securities. It’s an understandable concern as bonds tend to lose value when interest rates rise, and the Federal Reserve’s June projection called for a total of four increases in its benchmark interest rate this year.

As the chart below shows, during prior periods of rising interest rates, convertibles have performed better than 10-year US Treasuries.1 Therefore, in a rising-rate environment, we think convertibles can be a favorable place for fixed income investors to be.

That said, it’s a bit incomplete to compare the performance of convertibles to other fixed income investments given their characteristics. Convertibles are a unique asset class, offering investors features associated with bonds and the growth potential of common stocks.

A Bit of Background

Convertibles are generally structured as a form of debt (bonds, debentures) or preferred shares with an embedded option that allows conversion into common shares under predetermined
conditions. That embedded conversion option provides capital appreciation when the underlying common stock rises.

In a rising-rate environment where interest rates are rising for the “right” reasons—for example, strong economic and corporate earnings growth—equities tend to perform well. If the underlying common stock in a convertible security rises with the market, it should also increase in value because of the conversion option.

Conversely, if the common stock doesn’t perform well, the debt features of the convertible—interest payments and claim on principal—may provide some support. In this respect, convertibles act similarly to bonds, with characteristics that can potentially offer less value erosion in declining markets than the underlying common stock.