CONTRIBUTORS
Eric Webster, CFA
Portfolio Manager
John Anderson
Portfolio Manager
Key takeaways
- Convertible securities are the chameleons of the investment world, offering investors both the growth potential of common stocks and the diversification benefits of bonds.
- The convertibles asset class may expand as firms seek cost-effective financing and to attract investors to their common shares at the lowest possible cost.
- Convertible securities offer the potential for low correlation to other asset classes and a differentiated universe of opportunities relative to broad market benchmarks which may help reduce risk through portfolio diversification.
Bond-equity hybrids let investors keep their options open
The chameleons of the investment world, convertible securities, offer investors both the growth potential of common stocks and the income and relative security offered by bonds. Issued by companies looking to raise capital, these hybrid investments are generally structured as some form of debt (bonds, debentures) or preferred shares with an embedded option that allows conversion into common shares under predetermined conditions.
Convertibles are like bonds in their interest payments and claim to principal, and they are generally expected to provide better protection against erosion of value in declining markets than the underlying common stock. Typically, they mature in about five years, and at this point (absent a default caused by bankruptcy) the worst outcome is that an investor receives a full return of their initial investment.
Convertibles are also like stocks because their imbedded conversion component allows investors to benefit from rising share prices. If the company’s stock price goes up, the value of the convertible usually increases too, thanks to the option to convert it into common shares. At maturity, if the value of the shares is higher than the bond’s par value, investors can convert and enjoy some of that stock price gain. But investors don’t have to wait until maturity to benefit, convertibles adjust in price as the stock moves, offering a mix of potential stock upside and bond downside risk mitigation. Because of these special features, convertibles can be considered part of fixed income, equity or even a separate asset class altogether.
As securities that generate income, convertibles have historically offered a higher yield than the underlying common stock. This income adds to the overall return and helps balance the risk and reward. Investors often turn to convertibles during times of market volatility because they offer a way to stay invested in stocks with reduced downside risk. When markets rise, convertibles can also benefit from the increase in the price of the underlying stock. Their ability to perform in both up and down markets makes them a useful tool for diversifying a portfolio.
The Appeal of Balanced Convertibles
While convertibles can provide access to compelling corporate growth opportunities, we believe balanced convertibles may offer an attractive middle ground for investors seeking equity participation with a more moderate level of equity sensitivity. By combining both equity and bond characteristics, these securities may derive value from several sources, including current income, credit fundamentals, movements in the underlying equity and the embedded conversion option. Active management can help identify opportunities with strong issuer fundamentals, as well as attractive structures, valuations as individual securities move along the convertible spectrum over time.
Worldwide, convertible securities are garnering increasing attention from both issuers and investors. The asset class has ample room for expansion as companies look for financing and endeavor to attract investors to their common shares at the lowest possible cost. Convertibles offer attractive opportunities for participating in corporate growth, even in uncertain markets—possibly the strongest argument for including a component of convertible securities in a diversified portfolio of investments.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal.
Convertible securities risk: Which may be low-rated and which may act like either a bond (when the underlying equity value is well below par value for the security) or as stock (when the underlying equity value approaches or exceeds par value).
Credit risk: The risk of loss arising from default that may occur if an issuer fails to make principal or interest payments when due. This risk is higher if the portfolio holds low-rated, sub-investment-grade securities.
Foreign currency risk: The risk of loss arising from exchange-rate fluctuations or due to exchange control regulations.
Liquidity risk: The risk that arises when adverse market conditions affect the ability to sell assets when necessary. Such risk may be triggered by (but not limited to) unexpected events such as environmental disasters or pandemics. Reduced liquidity may have a negative impact on the price of the assets.