Bond, Convertible Bond - A Secret Agent For Your Equity Allocation?

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By Morningstar :

By Timothy Strauts

Convertible bonds are a niche asset class that often gets overlooked by most investors. There are currently only 16 mutual funds and just one exchange-traded fund that focus on the convertible-bond space. These funds have a combined $15 billion in assets. Investors' apparent lack of interest in this sector is somewhat surprising given that the Morningstar convertible-bond category has returned 7.6% annualized over the past 20 years. This beats the performance of the large-blend stocks category, which returned only 7.3% over the same period. Furthermore, convertible-bond funds achieved these returns with a risk level (measured by standard deviation) that was 22% lower than the large-blend category. Based on their track record, it would seem as though convertibles offer a compelling risk-adjusted return and could be a relatively less risky alternative to traditional equity investments.

The firm Butler|Philbrick|Gordillo & Associates has done research on the length of bull markets using data going back to 1871. It found that the median length of bull markets is 50 months and the median aggregate return during these bull runs has been 123%. Considering that the current bull market is 54 months long and the S&P 500 has climbed 152% over that period, it would appear that the current market rally may be drawing near its end. But that doesn't mean that investors should be trying to top tick the market and sell their equity holdings. After all, the longest bull market in history spanned from 1988 to 2000, and stocks had a cumulative return of 516% over that 12-year run. Instead, investors today may want to consider convertible bonds for a portion of their equity portfolios. This may provide investors the potential for equitylike upside with less downside risk.

To better understand the case for convertible bonds, it is important to understand how they work, how they compare with other equity alternatives, and how they perform in different interest-rate environments. It is also important to know what the options are for getting diversified exposure to the sector. The remainder of this article will cover each of these topics in turn.

What Is a Convertible Bond?
Convertible bonds are a hybrid security, having attributes of both fixed-income and equity securities. They are fixed-coupon bonds with a defined maturity date. They also grant the holder the option of exchanging the bond for common equity at a specified strike price. When issued, the strike price is usually 20%-30% higher than the current value of the stock. Many investors think of convertible bonds as a straight bond with an embedded call option. Because this embedded call option has some value to the end investor, the interest rate on a convertible will tend to be lower than that for a standard fixed-rate bond. The credit quality of companies issuing convertibles varies, but currently the average issuing firm has a credit rating of BB.

When investors buy convertible-bond funds, they get a collection of bonds with different performance characteristics depending on how the associated common stock has performed since the convertible was issued. If the stock has fallen in value, the convertible will behave more like a bond, and it will trade based on yield. If the stock has risen in value, the convertible will begin to trade more like the issuer's common stock. Owning a diversified basket of both of these "types" of convertibles in a fund blends the beneficial aspects of stocks and bonds together. The "equitylike" securities provide downside protection and income if the market performs poorly.

Bring on the Alternatives
High-yield bonds and long-short equity are two additional categories that investors have traditionally looked to as equity alternatives. Morningstar category return data is useful in making historical comparisons between these various types of equity alternatives. Category returns are calculated by taking a simple average of the returns for funds in a given category. Thus, Morningstar category returns provide an idea of what type of returns the average investor would have historically experienced in these asset classes.

Over the past 20 years there have been two major bear markets that provide an illustrative example of how these strategies perform in times of distress. The chart below shows the growth of $10, and the table provides a summary of the relevant performance statistics for each of these categories. The data shows that convertible bonds track large-blend stocks more closely than the other alternatives. Compared with large-blend stocks, convertibles have historically offered 77% of the upside with only 67% of the downside--as demonstrated by their upside and downside capture ratios in the table below. That may not sound impressive at first blush, but over the full period it meant that convertibles outperformed large-blend stocks on an absolute basis with lower volatility. During the 2008 financial crisis, convertible-bond funds performed poorly--losing 39.89% of their value--on average. That said, the category still fared better than the large-blend equity category. Large-blend stock funds lost 50.79% of their value--on average--during the most recent bear market.

High-yield bonds and long-short equity strategies are also positively correlated with large-blend stocks and historically have actually offered better downside protection than convertible bonds. However, as can be seen in the chart below, they haven't generated the type of equity-like returns that convertibles have.

(click to enlarge)
- source: Morningstar Analysts

(click to enlarge)
- source: Morningstar Analysts

Interest-Rate Sensitivity
It is also important to understand how these investment categories have held up in different interest-rate environments. To view this, one can rank the monthly percentage changes in the 10-year Treasury bond yield since 1978. For purposes of this analysis, the 20% of those months with the biggest interest-rate increase can be defined as periods of rising interest rates. The 60% of months in the middle will be defined as "neutral" rate environments. Finally, the 20% of months with the biggest decrease in interest rates will be deemed periods of falling interest rates. Having defined the rate environments, one can then assess how each category performed in those periods. The table below shows the annualized returns for each Morningstar category in each interest-rate period.

(click to enlarge)
- source: Morningstar Analysts

Historically, stocks and bonds have performed poorly during periods of rising interest rates. The data in the table support that conclusion, with all four categories performing the worst during times of rising rates. Convertibles outperform all other categories in periods of both rising and falling interest rates. It seems that convertibles perform best during the extremes of the interest-rate cycle. The hybrid nature of convertibles with a balance of bond-like and equity-like securities may help balance convertible funds' returns during large interest-rate movements. High-yield bonds and long-short equity strategies have historically performed very poorly in rising interest-rate environments. Overall, convertibles appear to offer the most consistent performance regardless of interest-rate period.

Investment Options
Currently, there are three mutual funds in the convertible-bond space that have a Morningstar Analyst Rating and one ETF that tracks the convertible-bond market. Bronze-rated Calamos Convertible (( CCVIX )) is the oldest fund in the space and the only one that is currently closed to new investors. The fund follows a more conservative strategy that focuses on investment-grade convertibles. This reduces risk but also limits its participation in bull markets. Neutral-rated Fidelity Convertible Securities (( FCVSX )) has the best performance over the past three years. These strong results are due to the fund's strategy of owning 60%-70% of the portfolio in "equitylike" convertibles. As such, in strong stock markets this fund should have an advantage, but it means that the fund will provide less downside protection when stocks head south. Gold-rated Vanguard Convertible Securities (( VCVSX )) , which is subadvised by Oaktree Capital, recently reopened to investors. This fund has a more international exposure and tends to own more nonrated issues because the manager believes it is an inefficient corner of the market. The Vanguard fund has a solid long-term record and a low expense ratio of 0.52%. SPDR Barclays Convertible Securities ETF( CWB ) is a new entrant to the convertibles space but has attracted assets quickly. This ETF follows a passive approach, tracking an index of U.S. convertible securities with an issuance size greater than $500 million. The ETF has the lowest expense ratio among the group and has offered competitive returns in its short lifetime.

(click to enlarge)
- source: Morningstar Analysts

Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Stocks

Referenced Stocks: CCVIX , CWB , FCVSX , VCVSX

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