How the Stock Market Pullback has Reshaped Convertible Opportunities

Key takeaways

Hybrid investments

Convertible securities are hybrid investments that can behave like stocks or like bonds.

Three types of converts

Convertibles can be considered equity-sensitive, balanced, or credit-sensitive.

New opportunities

While we continue to invest in balanced convertibles, we now see more opportunities in credit-sensitive converts

Convertible securities are hybrid investments that can behave like stocks or like bonds. Given the recent decline in stock prices, how has that impacted the opportunities we’re finding in the market?

Three categories of convertibles

Convertible securities contain a bond and a call option on an underlying common stock. Given where that underlying stock trades relative to its pre-stated conversion price, the convertible itself can be considered equity-sensitive, balanced, or credit-sensitive. Investors can utilize the different attributes associated with each type to achieve a targeted level of risk.

• Generally speaking, convertibles will become more equity-sensitive as the stock’s price moves further above its conversion price.
• Convertibles tend to trade more like a bond (credit-sensitive) as the stock’s price declines further below the conversion price. Credit-sensitive convertibles exhibit less equity sensitivity and more bond-like characteristics such as higher yields, higher conversion premium, and less downside risk relative to the common stock.
• In the middle are balanced converts, which possess both fixed income and equity attributes. This can provide investors with some downside support from the security’s bond floor, and some upside participation from its embedded call option.

Finding more bond-like opportunities

The stock market pullback has also caused a shift in the profile of the convertible market itself as the percentage of converts that are more credit-sensitive has grown from approximately 14% one year ago to a recent 43% according to Barclays.²  And nearly all that increase has come from the shrinking equity-sensitive portion of the market (54% one year ago to a recent 28%).²

While we continue to invest in balanced convertibles, which still make up about 1/3 of the universe, we now see more opportunities in credit-sensitive converts, which we believe are likely to move much less than their underlying stocks and provide yields in excess of those in the overall convertible universe.

Higher yields and shorter maturities

The average yield to maturity/put for all US convertible issues has climbed to 5.3% from 2.1% a year ago, due to a combination of lower security prices as rates have increased, higher coupons on newer issues and a decline in stock prices.³ Meanwhile, the comparable yield for the credit-sensitive U.S. convertibles basket is up to 7.7% compared to 4.6% a year ago.⁴

Additionally, we believe the shorter-term maturities of convertibles may be an advantage in today’s market. Most convertibles are issued with just five-year maturities and many contain call and/or put features, making their effective lives even shorter than that. The duration for the convert market is currently 2.3 years, compared to 4.2 years for the high yield market and 6.8 years for investment grade debt, according to Bank of America data.⁵ All else equal, the shorter duration of convertibles helps alleviate credit concerns to some degree, providing an added degree of comfort in investing in credit-sensitive convertibles.

Conclusion

Regardless of the market environment, our team is focused on what we believe is the best opportunity in the convertible universe –issues that may offer both upside participation should their underlying stocks rise and may offer downside support via the securities’ fixed income attributes. We are selectively adding credit sensitive bonds to the portfolio, which we believe may provide worthwhile returns and downside protection at lower prices, while offering attractive yields.

Footnotes

• 1Source: BofA Merrill Lynch as of 10/1/22
• 2Source: Barclays Research reports dated 10/1/21 and 9/23/22
• 3Source: Barclays Research data as of 9/23/22 
• 4Source: Barclays Research reports dated 10/1/21 and 9/23/22
• 5Source: BofA Merrill Lynch as of 10/1/22

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Originally Posted October 28, 2022 – How the stock market pullback has reshaped convertible opportunities

Important Information

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This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional before making any investment decisions.

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Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating. Junk bonds involve a greater risk of default or price changes due to changes in the issuer’s credit quality.

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Convertible securities may be affected by market interest rates, issuer default, the value of the underlying stock or the right of the issuer to buy back the convertible securities. Investments in convertible securities are subject to the risks associated with both fixed-income securities, including credit risk and interest rate risk, and common stocks. Convertible securities may have lower yields because they offer the opportunity to be converted into stock and if the stock is underperforming and the bond does not convert then the bond may have a lower return than a non-convertible bond.

A convertible security is an investment that can be changed into another form, such as convertible bonds that can be changed into common stock.

A put option gives an investor the right to sell a security at a specified price within a certain time frame.

A call option gives an investor the right to buy a security at a specified price within a certain time frame.

Yield to put and call: the total return on a bond that has an embedded put option to sell it back to the issuer if the puttable bond is held until the earliest permissible date when the put option can be exercised at a fixed price – typically at face value.

Yield to maturity is the percentage rate of return for a bond assuming that the investor holds the asset until its maturity date. It is the sum of all of its remaining coupon payments. A bond’s yield to maturity rises or falls depending on its market value and how many payments remain to be made.

Duration is a measure of the sensitivity of the price of a bond or other debt instrument to a change in interest rates. In general, the higher the duration, the more a bond’s price will drop as interest rates rise (and the greater the interest rate risk).

The ICE BofA US Convertible Index is an unmanaged index that measures performance of US dollar-denominated convertible securities not currently in bankruptcy with a total market value greater than $50 million at issuance.

The opinions referenced above are those of the author as of Oct. 3, 2022. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.