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If an underlying security’s shares rise significantly, convertible bondholders can participate in that growth, and do an exchange for a set number of common shares.William_Potter/iStockPhoto / Getty Images

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Convertible bonds were a hot asset just a few years ago as equity markets surged, and this niche corner of fixed income soared along with them.

After fast-rising interest rates and falling equity markets – a toxic mix for convertibles – led to steep losses last year, convertibles are again on advisors’ radar with a flurry of recent issues including well-established, investment-grade companies.

“Convertibles can make sense for those investors who want equities-like returns but lower volatility, downside principal protection and coupon income,” says Chiayi Tsui, fixed-income analyst and manager of research at Morningstar Research Services LLC in Chicago. “Their hybrid nature is really their main proposition.”

In previous bull equities markets, convertibles have proven their value, capturing equities-like growth with those added protections.

That includes 2020 when, for example, iShares Convertible Bond Index ETF CVD-T, which tracks the U.S. convertibles market for issues of at least US$250-million, posted an almost a 62 per cent return.

At the time, the market was led mostly by speculative technology companies, Tesla Inc. TSLA-Q most notably, Ms. Tsui says.

“Convertibles offer these companies a cheaper way to access capital,” even when interest rates were at historical lows.

At the time, some issues were no-coupon convertibles, which only offered principal protection – barring bankruptcy – in exchange for the opportunity to convert to stock at some point, she says.

More recently, established firms such as ON Semiconductor Corp. ON-Q, Palo Alto Networks Inc. PANW-Q, American Water AWK-N and even Ford Motor Co. F-N, among others, have issued convertibles.

Of course, investors must consider the reason behind the recent spate of issues, says Doug Nelson, a portfolio manager at Nelson Portfolio Management Corp. in Winnipeg.

“As with any security, it’s important to ask why they’re offering a sweetener to investors,” he says. “That question certainly applies to convertibles today.”

Reasons to consider convertibles

Amid higher interest rates, convertible bonds offer companies a cheaper way to raise capital because of their lower coupons, which can be a few hundred basis points lower than investment-grade corporate bonds, says Diana Orlic, portfolio manager with Orlic Harding Cooke Wealth Management Group at Richardson Wealth Ltd. in Burlington, Ont.

She compares a convertible from Southwest Airlines Co. LUV-N versus senior, unsecured debt as an example.

“These are two [Southwest] bonds, issued [at the same time] and maturing the same year,” but the convertible coupon is 1.25 per cent and the traditional bond coupon is 5.25 per cent, she adds.

The reasons for investors to consider the convertible over senior debt, even with the significantly lower coupon, are twofold.

If the underlying security’s shares rise significantly, convertible bondholders can participate in that growth, and exchange it for a set number of common shares, Ms. Orlic says.

Also, as convertible bonds’ prices rise with the stock price, bondholders can sell them to realize a potential capital gain. If shares decline, bondholders may not want to convert to equity because they likely would realize a loss. Yet, they can still hold to maturity, earn the coupon, and get their principal back.

“Clients get the best of both worlds,” says Ms. Orlic, who allocates a small part of portfolios to convertibles.

Understanding the risks

Yet, these investments are more complex than they might appear to investors, which can present a problem for advisors, who themselves may not have much experience in this hybrid but “niche” asset class, says Konstantin Boehmer, senior vice president, portfolio manager and co-head of the fixed-income team at Mackenzie Investments in Toronto.

“The big issue is the propensity to misunderstand their risks,” he says.

Those risks certainly manifested in late 2021 and into the first half of 2022, when “convertibles actually performed worse than equities.”

Mr. Boehmer further explains falling equity markets and fast-rising rates fuelled their decline, but so did the fact that the convertible market is less liquid than equities and traditional fixed income. Compounding the problem for retail investors is access, he adds.

It’s challenging to purchase newly issued convertible bonds. Most are purchased on the market and, like stocks, investors often chase returns of strong performing convertibles, potentially buying them at their peak when the risks are also highest, Mr. Boehmer says.

In short, investing successfully in convertibles requires expertise, for example, in sorting through a diversity of maturities and specific timeframes for conversion to equity.

“A quick Bloomberg search revealed convertibles maturing this year, all the way up to 2113,” Ms. Orlic notes.

The coupon, the conversion price, and the conversion ratio – how many shares the investor receives – are other considerations.

Convertibles also require analysis of the issuing companies’ potential share price growth.

“That’s why there are [portfolio] managers who dedicate their careers just to convertibles,” Ms. Tsui says.

She further notes often hearing from these portfolio managers how convertible bonds attract retail investors chasing returns after prices have run up, only to flee the space when convertibles’ fortunes reverse, sustaining equities-sized losses.

This year and last illustrate this point with convertible bond funds seeing net outflows, Ms. Tsui adds.

Still, funds offer the most cost-effective, diversified exposure to convertibles for most clients.

“This is one part of the market [in which] they might do well looking to actively managed funds,” Ms. Tsui says, due to the complex factors affecting convertibles.

Even then, it can be difficult for advisors to sort through funds’ holdings, weighing opportunities for growth versus risks, Mr. Boehmer says.

“There can be a lot of embedded risk that may not be obvious,” he adds.

Although often riskiest when stock markets are soaring, the inverse can be true.

Convertibles’ greatest growth potential can emerge after a rout in stocks, providing risk-adjusted equity exposure with the “hedge,” if prices do not rise, of income and principal protection, Ms. Orlic notes.

“The client can win either way,” she says.

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Tickers mentioned in this story

Study and track financial data on any traded entity: click to open the full quote page. Data updated as of 13/06/24 9:35am EDT.

SymbolName% changeLast
Ishares Convertible Bond Index ETF
Tesla Inc
On Semiconductor
Palo Alto Networks Inc
American Water Works
Ford Motor Company
Southwest Airlines Company

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