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Stocks and bonds seem unsafe? Try convAertibles
USINFO | 2013-11-13 09:58
Investors can’t decide which scares them more right now, a bond market poised for massive changes as interest rates keep rising, or a stock market that has reached record highs despite a weak economy.
For investors who aren’t completely happy with either side of the stocks-bonds picture, convertible securities offer an interesting way to straddle the fence.
While convertibles are esoteric enough that many investors reject them out of hand, they’re attractive enough that they’re showing up in more funds. There have been more convertible securities issued year-to-date than a year ago, and the increasing supply has brought a few managers off the shelves and into the market.
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Most recently, Calamos Convertible Securities CCVIX +0.16% was reopened to new investors , with company chief executive John Calamos noting that widening spreads have increased interest among issuers. Perhaps more important is that convertibles, historically, do better than more traditional fixed-income securities at times when rates are rising.
To understand why, let’s start at the beginning and examine how these securities work.
Convertible securities are hybrids, typically interest-paying bonds (but sometimes preferred stock) that can be swapped for shares of the issuing company’s stock at a predetermined price. The bond-like-yield aspect of a convertible protects against stock declines, while the ability to convert into stock offers shelter against falling bond prices.
When interest rates are going up, bond prices fall; but in a market like we have now—where stocks have been on the rise—an investor can get the best of both worlds.
Said Calamos at the time his fund re-opened: “The equity portion of the convertible market pulls it along with the equity market, so that’s been positive for convertibles in a rising interest-rate environment. So you have many investors looking at convertibles as part of their fixed-income asset allocation.”
If you think of a convertible like a car, investors get to put the top down when the sun is shining, but they can cover up for protection when things get stormy.
Money managers who use convertibles frequently say that they expect the investment to deliver about two-thirds of stock-market returns with half of the downside risk, meaning a convertible fund would gain around 6.5% for every 10% market rise, but fall just 5% during a 10% market correction. That’s attractively conservative.
In practice, convertibles have been a good diversifier to balance the stock and bond chunks of a portfolio.
For the past five years, the average convertible fund had an annualized return of 8.75%, just a bit less than the average large-cap-growth fund, but better than might be expected. That five-year history still includes a lot of the financial crisis of 2008, a point when convertibles lost ground but showed their protective side (the average convertible fund lost 33% in ’08; Standard & Poor’s 500 declined 37%).
On the fixed-income side, the average high-yield bond fund gained a hair under 10% over the past five years, a bit better than convertibles. But over the past 12 months—when the rate environment has been changing and stocks have been reaching new heights—the average junk-bond fund gained 1.1%, compared with 6.1% for convertibles.
At the same time, convertibles are an area where even do-it-yourself investors may want to hire a money manager, if only because many of the issues carry investment ratings that are below investment grade. While defaults are not particularly common, “busted convertibles”—where the convertible price is 50% or more above the current price, making the chance of converting into stock slim—are not uncommon. Many convertible managers—particularly those running closed-end funds looking for good income—will buy busted convertibles on the cheap. (Really, a busted convertible could be called a non-convertible, since it’s never going to morph.)
Thus, this is one of those cases where interested investors can get some comfort from having a professional manager and a diversified portfolio that can minimize the pain if any single issue goes bad.
David Snowball, publisher of the Mutual Fund Observer, an online newsletter, noted that investors don’t necessarily need a convertibles fund or closed-end offering to get exposure, as many “strategic income funds” include them as a holding.
Calamos, in announcing his fund’s re-opening, said, “One of the things we have learned over the years is that convertibles are not specifically an asset class. It’s how you use them to manage risk that’s very important.…It’s a way we feel we can manage risk.”
For investors who aren’t completely happy with either side of the stocks-bonds picture, convertible securities offer an interesting way to straddle the fence.
While convertibles are esoteric enough that many investors reject them out of hand, they’re attractive enough that they’re showing up in more funds. There have been more convertible securities issued year-to-date than a year ago, and the increasing supply has brought a few managers off the shelves and into the market.
Most recently, Calamos Convertible Securities CCVIX +0.16% was reopened to new investors , with company chief executive John Calamos noting that widening spreads have increased interest among issuers. Perhaps more important is that convertibles, historically, do better than more traditional fixed-income securities at times when rates are rising.
To understand why, let’s start at the beginning and examine how these securities work.
Convertible securities are hybrids, typically interest-paying bonds (but sometimes preferred stock) that can be swapped for shares of the issuing company’s stock at a predetermined price. The bond-like-yield aspect of a convertible protects against stock declines, while the ability to convert into stock offers shelter against falling bond prices.
When interest rates are going up, bond prices fall; but in a market like we have now—where stocks have been on the rise—an investor can get the best of both worlds.
Said Calamos at the time his fund re-opened: “The equity portion of the convertible market pulls it along with the equity market, so that’s been positive for convertibles in a rising interest-rate environment. So you have many investors looking at convertibles as part of their fixed-income asset allocation.”
If you think of a convertible like a car, investors get to put the top down when the sun is shining, but they can cover up for protection when things get stormy.
Money managers who use convertibles frequently say that they expect the investment to deliver about two-thirds of stock-market returns with half of the downside risk, meaning a convertible fund would gain around 6.5% for every 10% market rise, but fall just 5% during a 10% market correction. That’s attractively conservative.
In practice, convertibles have been a good diversifier to balance the stock and bond chunks of a portfolio.
For the past five years, the average convertible fund had an annualized return of 8.75%, just a bit less than the average large-cap-growth fund, but better than might be expected. That five-year history still includes a lot of the financial crisis of 2008, a point when convertibles lost ground but showed their protective side (the average convertible fund lost 33% in ’08; Standard & Poor’s 500 declined 37%).
On the fixed-income side, the average high-yield bond fund gained a hair under 10% over the past five years, a bit better than convertibles. But over the past 12 months—when the rate environment has been changing and stocks have been reaching new heights—the average junk-bond fund gained 1.1%, compared with 6.1% for convertibles.
At the same time, convertibles are an area where even do-it-yourself investors may want to hire a money manager, if only because many of the issues carry investment ratings that are below investment grade. While defaults are not particularly common, “busted convertibles”—where the convertible price is 50% or more above the current price, making the chance of converting into stock slim—are not uncommon. Many convertible managers—particularly those running closed-end funds looking for good income—will buy busted convertibles on the cheap. (Really, a busted convertible could be called a non-convertible, since it’s never going to morph.)
Thus, this is one of those cases where interested investors can get some comfort from having a professional manager and a diversified portfolio that can minimize the pain if any single issue goes bad.
David Snowball, publisher of the Mutual Fund Observer, an online newsletter, noted that investors don’t necessarily need a convertibles fund or closed-end offering to get exposure, as many “strategic income funds” include them as a holding.
Calamos, in announcing his fund’s re-opening, said, “One of the things we have learned over the years is that convertibles are not specifically an asset class. It’s how you use them to manage risk that’s very important.…It’s a way we feel we can manage risk.”
