In today's low interest rate environment, investors need to make maximum use of all available asset classes when they construct their portfolios. One, often under appreciated asset class are convertible bonds. A convertible bond is simply a bond which can potentially be converted to shares.
Advantages of convertible bonds
The attraction of convertible bonds is clear. If a company struggles and its stock price falls, the investor can hold onto their bond and continue to receive their coupon. If the stock does well, the investor can convert his bond to equity and enjoy the benefits of capital growth which come from a higher stock price. They have the upside potential of equities and the downside protection of bonds and therefore have the potential to provide very strong risk-adjusted returns.
Convertibles also typically have a lower duration than conventional bonds. This means they are less sensitive to movements in interest rates. This is important because it means they have a low correlation with other fixed interest. They can be a useful part of your portfolio because lower correlation means better diversification. i.e. if one part of your portfolio goes down the rest of it will not necessarily be affected.
Another potential benefit of convertible bonds is that they provide exposure to volatility. As markets become more volatile the value of the option to convert the bond into shares rises.
The benefits of convertible bonds don't come for free. Because they provide the option to convert the bonds into shares, companies are able to sell the bonds at a lower yield. Therefore you won't be able to generate as much income. One danger of convertibles is that they are sometimes issued by distressed companies wanting to keep their interest payments low. This is not necessarily a problem as if the company survives it's share price can often do very well and the convertible bond will be worth a lot. However, it does mean you need an experienced active manager who can do proper due diligence.
There are also a limited number of convertible bond issues available; many companies won't bother to issue them. However, there is still a universe of about 1,900 convertible bonds. The annual issuance of convertibles is currently quite low; because yields are already depressed, companies don't feel the need to issue them. That's why David Basile, fund manager of the RWC Global Convertible bond, says he 'can't wait for interest rates to rise'. It's highly unusual to hear a bond manager so enthusiastic about a rise in interest rates, but David believes higher rates will lead to a greater issuance of new convertibles giving him more investment opportunities.
Convertible bond funds
There are a few convertible bond funds available. We mentioned the RWC Global Convertibles fund above. David was previously head of convertible bonds at Morgan Stanley. He says, 'The unique selling points of convertible bonds do hold true through a multitude of different cyclical market environments'. The fund has returned 30.49% over the past 3 years.* There is also a JPM Global Convertibles, M&G Global Convertibles and Polar Capital Global Convertibles bond fund available.
Investors may want to take a closer look at this unappreciated asset class. It has the potential to provide important diversification and great risk-adjusted returns if you can find the right fund.