Convertible bonds’ traditionally higher returns can be attractive compared with returns from traditional core bonds.
However, convertible bonds’ risk-and-return profile aligns more closely with stocks than with most fixed income investments.
We believe any investment in convertible bonds should come from the “aggressive income” allocation, or even the equity allocation—not the “core” fixed income allocation—of an investor’s overall portfolio.
Are you looking for stocks or bonds? That’s a relevant question to ask when considering investing in convertible bonds.
Convertible bonds are a type of debt security that can be converted to a fixed number of shares of the issuer’s common stock. While they are technically bonds, some features differentiate them from traditional fixed income investments. Perhaps most notably, over time they tend to perform more like stocks than like high-quality bonds.
If you’re considering investing in convertible bonds, it’s best to understand their basic characteristics and how they may fit into your asset allocation. Given their stock-like characteristics, we think you should consider them as part of your aggressive income allocation, or even your equity allocation, rather than as a substitute for traditional, high-quality fixed income holdings.
Understanding the basics of convertible bonds
Convertible bonds have set maturity dates and generally have fixed coupon rates and par values. Unlike traditional corporate bonds, however, convertible bonds can be converted into a set number of shares of the issuer’s common stock. There are various types of convertible bonds—some may be converted at the option of the bondholder, while some are “mandatory” convertibles that generally convert to common shares at maturity.
The conversion ratio represents how many shares of common stock the bond can be converted to. For example, a 10-to-1 ratio would mean that one bond can be converted into 10 shares of common stock.
The conversion price is the price at which the number of converted shares is equal to the par value of the bond. When convertible bonds are issued, the price of the underlying stock is usually below the conversion price, and the amount by which the conversion price exceeds the current stock price is called the conversion premium.
The performance of convertible bonds has historically been more correlated to stocks than to high-quality bonds (correlation is a statistical measure of how two investments move in relation to each other—a reading of 1 indicates a perfectly positive correlation, while a reading of -1 indicates a perfectly negative correlation).
Convertible bonds have had a higher correlation with stocks than with bonds
Source: Schwab Center for Financial Research with data from Morningstar, Inc. Correlations are between monthly total returns from February 1997 through January 2017. Correlation is a statistical measure of how two investments move in relation to each other. Indices represented above are the Bloomberg Barclays U.S. Convertibles Composite Index, Barclays U.S. Aggregate Bond Index, Bloomberg Barclays U.S. Corporate High-Yield Bond Index, and the S&P 500 Index.
The benefits of fixed income holdings can vary among the different types of investments
We believe fixed income investments can provide three key benefits: income, relative price stability and diversification. With a high correlation to stocks, and almost no correlation to core U.S. bonds, convertible bonds don’t offer the diversification benefits that most fixed income investments provide. And with coupon payments generally lower than traditional corporate bonds, they don’t provide much of an income benefit, either.
However, the return from convertible bonds historically has been higher than that of other fixed income investments. As the chart below illustrates, the annualized total return of convertible bonds is very similar to that of domestic stocks. While returns have generally been higher than many other fixed income investments, they come with more volatility as. Our standard deviation measure below illustrates the volatility of certain types of investments’ total return—the greater the standard deviation, the greater the volatility.
Risk and return varies by type of fixed income investment
Source: Schwab Center for Financial Research with data provided by Morningstar, Inc., using the following indices: Bloomberg Barclays U.S. Aggregate Bond Index, Bloomberg Barclays U.S. Corporate Bond Index, Bloomberg Barclays U.S. Corporate High Yield Bond Index, BofA Merrill Lynch Fixed Rate Preferred Securities Index, Bloomberg Barclays U.S. Convertibles Composite Index and the S&P 500 Index. Risk and return calculated using monthly returns from February 2007 through January 2017. Returns assume reinvestment of bond principal and interest and are not adjusted for taxes. Indices are unmanaged, do not incur fees or expenses, and cannot be invested in directly. Past performance is no indication of future results.
Although convertible bonds share risk and return characteristics with stocks, most convertibles offer more downside protection than stocks. If the price of the underlying stock drops, the price of the convertible bond may still remain close to its par value. Mandatory convertibles, however, may drop in value if the price of the common stock has fallen since the issuance of the convertible security. And if revenues and earnings deteriorate significantly, convertible bonds can still default, however, just like traditional corporate bonds.
Because of the potential to benefit from an increase in stock price appreciation, convertible bonds tend to offer lower coupon rates than traditional corporate bonds, regardless of credit rating. Traditional corporate bonds’ coupon payments and value at maturity aren’t affected by improving corporate earnings or a rising stock price, although those things may make it easier for the issuer to make timely interest and principal payments.
The average coupon rate on convertible bonds is lower than most other types of corporate securities
Source: Bloomberg, as of 2/17/2017. Indexes represented are the Bloomberg Barclays U.S. Aggregate Bond Index, Bloomberg Barclays U.S. Convertibles Composite Index, Bloomberg Barclays U.S. Corporate Bond Index, Bloomberg Barclays U.S. Corporate High-Yield Bond Index and the BofA Merrill Lynch Fixed Rate Preferred Securities Index.
Creditworthiness of convertible bond issuers may be difficult to assess
The lower coupon rates for convertible bonds aren’t necessarily an indication of risk, however. Convertible bonds tend to have relatively low credit ratings or no credit ratings at all. The average credit rating of the Bloomberg Barclays U.S. Convertibles Composite Index is Ba1/Ba2, using Moody’s Investors Service’s credit rating scale, but that may understate the credit risk.1 More than half of the index is not rated at all, making it difficult for investors to get an opinion on the creditworthiness of the issuer. Many convertible bond issuers tend be high-growth companies that are still in the early stages of their business, so they may forgo paying for credit ratings. And less than 20% of the index is composed of issuers with investment-grade ratings, which means when compared with investment-grade corporate bonds, convertibles bond generally offer lower income payments but higher risk.
Most of the convertible bond market has sub-investment grade ratings or no ratings at all
Source: Bloomberg, as of 2/27/2017.
The industry composition of the convertible bond market is also very different from the traditional corporate bond market. Technology issuers make up 39% of the convertible bond index but only 8% and 7% of the investment-grade and high-yield corporate bond indexes, respectively. That is likely due to the high growth potential for technology companies today. Convertible bonds allow them to issue debt with relatively low yields, and although the bonds may be converted down the road, it isn’t immediately dilutive to current stockholders.
What to do now
Convertible bonds generally offer lower yields than traditional bonds, but they have the potential to generate higher total returns if stock prices rise. Over time, they tend to perform more like stocks than bonds. As such, for investors considering convertible bonds, we think any allocation to them should come from the aggressive income or equity portion of an investor’s overall portfolio, not the fixed income portion.
1 As of February 27, 2017. The average credit rating of Ba1/Ba2 implies that the average credit rating is between those two individual ratings.