Our Blog Feb 09, 2017
Convertible securities are coming off strong gains over the past year. Can they still deliver?
Convertible securities have provided S&P 500-like returns over the last 40 years, but with more income and less volatility. Yet, the typical investor has little or no exposure to this asset class. Convertibles returned more than 20% in the past year, and while a repeat of that performance level is unlikely in the immediate future, the outlook remains favorable. They continue to be an attractive long-term option for investors who are looking for exposure to stocks and also want some income.
Convertible securities are a type of hybrid security that pay interest like bonds and can be swapped for stock when shares rise above a fixed price. They offer two traditional features that may be attractive in a period of high stock prices and rising interest rates; they tend to earn returns approaching those of stocks with less volatility and often outperform traditional bonds in a rising interest rate environment.
Although last year’s return of more than 20% is probably unsustainable, today’s conditions still make a strong case for a long-term allocation to convertibles:
- Growth opportunities: U.S. stocks rallied at the end of last year, but some high-growth areas that participate in the convertible securities market have not fully recovered. For example, semiconductors advanced in the past year, but many other industries — such as biotech and software — remain below 2015 highs.
- More convertible deals: After several years with low issuance, the pace of new convertible securities issued by companies has been increasing, and an even higher level of issuance is likely this year. New issues have been well-diversified across sectors.
- Credit spreads at normal levels: Credit spreads tightened quickly from unusually high levels last year and have returned to normal levels. When credit spreads are too tight, convertible securities struggle, but that is not the case today.
- Stability in the energy sector: Companies in cyclical industries that are coming out of a downturn, such as energy, often issue convertible securities to raise capital to fund new projects, because it can be quicker and cheaper than going through the bond market. Following the partial recovery in oil prices and the November OPEC agreement, more energy-related companies are now issuing convertible securities.
- Macroeconomic tailwinds: Although investing in convertible securities should be driven by fundamental analysis rather than macro factors, the current environment is favorable for convertible securities.
- Rising interest rates: Convertibles have a history of outperforming traditional bonds in a rising rate environment.
- Increasing economic growth and commodity prices: These conditions favor the average convertible issuer while providing some challenges for stable, dividend-paying equities, which typically correlate with bond price movements. The stocks that underlie convertible securities have smaller market caps and are more domestic than typical dividend-paying stocks.
After a strong rally over the past year, convertible securities remain an attractive way to get exposure to the stock market but with less volatility and more income. But most retail investors are missing the opportunity and should consider adding convertibles to their portfolios — especially if U.S. stocks weaken after their recent rally.