Convertible bonds are getting renewed attention on Wall Street as an asset class that can do well both in high- and low-inflation environments.
Convertibles are bonds that can be converted to shares of the issuing company’s stock. In certain circumstances—such as when the economy is firing on all cylinders or when inflation is higher—convertibles should behave more like equities. But in other situations—such as during a recession—they should behave more like debt.
It’s easy to understand why some investors are showing interest in convertibles. Inflation is already at a 40-year high and could very easily rise even further in coming months. But it also isn’t unlikely that within the next 12 to 18 months, inflation will be a lot lower than it is today. The Philadelphia Federal Reserve Bank reports that the consensus among professional economic forecasters is that inflation in 12 months’ time will be below 3%.
Convertibles offer the possibility of performing well in both environments—at least in theory. How well do they perform in practice?
To find out, we analyzed the historical performance of mutual funds in Morningstar’s US Fund Convertibles category. This category’s average significantly outperformed the various categories of traditional bonds since 1957 and nearly kept up with stocks (see chart below). Over the entire 65-year period, the category produced an annualized return of 9.3% versus 10.6% for the
S&P 500 index,
7.2% for corporate bonds, 6.7% for long-term Treasury bonds, and 6.1% for intermediate-term Treasuries.
This is right in line with these asset classes’ relative riskiness. Because convertibles are riskier than conventional bonds, you’d expect them to do better. But because investors don’t have to convert them when stocks are performing poorly, convertibles are less risky than stocks. You’d therefore expect them to lag the S&P 500 over the long term.
If that was all there was to this story, then your decision about convertibles would be a simple function of your risk tolerance. Convertibles would enable you to go further out the risk spectrum than traditional bonds without going as far as equities.
But convertibles’ unique characteristics make them relatively uncorrelated with either stocks or bonds, according to Michael Miller, president and chief investment officer of Wellesley Asset Management, a Massachusetts firm that focuses on convertibles. Miller told Barron’s that this means convertibles can play a valuable role in your asset allocation, reducing your portfolio’s volatility more than they forfeit returns.
Miller in particular drew attention to convertibles’ historical returns during periods of rising inflation. Traditional bonds typically suffer during such periods, as they indeed have over the past year. Convertible bonds, by contrast, are far more correlated with stocks during such periods, he said.
|Calendar years since 1957…||Convertibles funds||S&P 500||LT Treasuries||IT Treasuries||Corporate bonds|
|When inflation is higher than in preceding year||6.5%||6.5%||4.4%||4.7%||5.2%|
|When inflation is lower than in preceding year||11.6%||14.1%||8.6%||7.2%||8.9%|
|When 10-year yield is higher than in preceding year||7.6%||8.7%||2.4%||3.8%||2.7%|
|When 10-year yield is lower than in preceding year||13.0%||13.2%||12.4%||9.0%||13.0%|
|When S&P 500 rises||14.6%||18.3%||6.8%||5.9%||8.2%|
|When S&P 500 falls||-8.2%||-13.3%||6.1%||6.7%||3.7%|
Sources: Morningstar Direct; Hulbert Ratings
The relevant data are summarized in the above table. In all calendar years since 1957 in which inflation was higher than in the preceding year, convertible funds produced an annualized gain of 6.5%—equaling the S&P 500’s return and significantly outperforming traditional bonds. In years in which inflation was lower than in the previous year, the average convertible fund still did better than traditional bonds, though not as well as the S&P 500.
Similar patterns emerged when dividing the years according to whether the 10-year yield was higher or lower than the preceding year, and according to whether the S&P 500 gained or lost.
It’s always possible that the future won’t be like the past, of course. And this is especially the case with investments such as convertible bonds that appear to outperform the market on a risk-adjusted basis. It’s always possible that investors have discovered the free lunch that these bonds have, in effect, provided in the past, and by purchasing them investors have discounted away the advantage.
Miller, for one, doesn’t believe this has happened. He pointed out two reasons why he thinks the market for convertibles remains relatively inefficient. One is that it is fairly small, with a market cap of roughly $400 billion. In contrast, the size of the entire bond market is $53 trillion, according to the Securities Industry and Financial Markets Association. Convertible bonds are barely more than a drop in the bond market bucket.
The other reason that convertibles’ advantage may not have been discounted away is that it’s difficult to calculate what a convertible bond’s fair value is. A key component of its valuation is the option to convert to equity, and it isn’t obvious how to put a fair value on that option. Upon making several calls to seasoned market experts and researchers, we failed to find anyone who felt confident in knowing how to do so.
The bottom line? Convertible bonds are an underutilized and potentially undervalued asset class that very well could play a worthwhile role in a diversified portfolio of stocks and traditional bonds.
Diversification is key with this asset class, which is easy to accomplish with a mutual fund or exchange-traded fund. The ETF benchmarked to the convertible asset class with the most assets under management is
SPDR Bloomberg Convertible Securities
(ticker: CWB), with $4.7 billion in assets under management and an expense ratio of 0.40%, or $40 per $10,000 invested.
Mark Hulbert is a regular contributor to Barron’s. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at firstname.lastname@example.org.