Convertible investments have been touted as offering the best of both worlds: the stability of fixed income coupled with the upside of equities.
But these securities aren’t as simple as that.
Convertible bonds let investors convert their holdings to common stock at a time of their choosing within the term of the investment (generally five to seven years).
However, if the company goes bankrupt, all other fixed-income investors will be paid before convertible bondholders, says Eric Dzuba, AVP, Investment Management, Mackenzie Investments in Toronto. That’s why a company has to be strong on the credit side, “because often the recovery rates on these types of securities isn’t great.”
Stu Spangler, managing director and portfolio manager, Oaktree Capital Management in Los Angeles, agrees it’s important to look at creditworthiness. “We focus on conservatively rating the credit because, if we do the credit work right, the bonds will hold up in an equity decline.”
He uses Moody’s and S&P ratings, when available, to determine if a company is creditworthy. But if it’s a non-rated security, he’ll make a conservative rating based on how its competitors stack up. He’ll also look at the company’s leverage ratios, interest coverage ratios and working capital needs.
So how can you determine if convertible investments belong in your client’s portfolio? Consider these factors.
They’re like bonds, but not
Typically, convertibles have five- to seven-year terms during which a purchaser can convert them from bonds to stocks. As such, they’re considered hybrids between the two instruments. On the fixed-income side, explains Dzuba, the coupon is generally lower than a regular bond.
“Your tradeoff is the ability to participate in the equity upside,” he says. “If we look at the history of these securities, they have generally returned 80% of the equity upside, and only captured about 60% of downside. So they have equity-like returns with less than equity-like volatility.”
So, in the current low interest-rate environment, the equity aspect of convertibles gives investors a chance for better returns, compared to regular bonds. “T-Bills, GICs and government bonds are paying you around 1% on average,” notes David Stonehouse, VP and portfolio manager, AGF Investments, in Toronto. “You’re no longer in a world where you can build wealth through [straight] bonds.”
And, convertibles can outperform regular bonds in a rising interest-rate environment. He illustrates this with data from four time periods when 10-year U.S. bond yields increased at least 100 bps: summer 2003 to 2004, summer 2005 to 2006, end of 2008 to spring 2010, and summer 2012 to 2013.
“The rise in yields was anywhere from 130 bps to 200 bps, around 2%. Bonds generally don’t do well in a rising interest-rate environment—the bond market was basically flat.” However, based on the Barclays U.S. Index, convertible bonds delivered more positive returns during those periods. “They were up 12% to 60%,” he notes, adding the highest increase happened after the crisis and isn’t typical.
Still, just because convertibles are producing good yields, they’re more volatile than regular bonds, says Stonehouse. “You want high-quality bonds as the stable anchor of your portfolio,” he adds. “But investors have historically benefited from a small allocation out of regular bonds and into converts to supplement core, regular bond allocation.”
If an investor has a 60/40 portfolio, he recommends putting 10% to 20% of the bond portion into convertibles. That’s 4% to 8% of an investor’s overall portfolio, depending on his objectives and risk tolerance. Further, “the benefit of converts would probably be greater after a bear market in riskier assets, and after a rally in regular bonds.”
Also, the complexity of these securities does not make them suitable for DIY investors, notes Dzuba. “You want a professional manager looking at a portfolio of these securities. He’ll need to evaluate the relative value between the price of the option and the bond, and the yield the bond offers.”
The U.S convertibles market in 2014
|Total market size||$207.7 billion|
|Average market yield||2.27%|
|Average conversion premium||34.80%|
Dzuba adds that, since convertibles help de-risk portfolios with larger equity holdings, he typically suggests them to investors who are five to 10 years pre-retirement—that’s the stage at which they’ll likely start taking on less risk. “It’s not that they’re unsuitable for younger investors. But younger people who are in the accumulation stages are able to handle the volatility of an equity portfolio.”
The benefits for suitable investors are clear. But, aside from raising capital, why would a company issue a convertible?
“They pay out interest income,” explains Stonehouse. “They have coupons, and therefore you still get the interest-rate deductibility from your income statement if you’re a corporation. So it can be beneficial from a tax perspective.”
He adds, “The coupons tend to be somewhat lower than straight corporate debt, because you get that embedded call-option feature. It’s a little bit cheaper than issuing straight debt, which necessitates a slightly higher coupon.”
It’s also cheaper than issuing straight equity. Why? “If you issued straight equity, it’s dilutive right away if the share price goes up,” notes Stonehouse. “Whereas, with convertibles, that only kicks in after the stock’s already risen enough to move through the conversion premium. So it’s a little bit less dilutive by share count.”
To determine the conversion premium, issuers and investors would look at how many shares of stock you get for every $1,000 of bond. While he’s seen premiums ranging from 10% to 70%, he says the average is 30% to 40%.
Another advantage for companies is that convertibles stabilize a balance sheet.
“If the company does really well and the stock price goes up a lot, chances are the convertibles are going to convert to stock,” he says. “Automatically, your leverage goes down.”
A look at specific companies
Spangler typically sees mid- and small-cap companies issue convertibles. And, often, they’re energy, financial services, healthcare or technology firms, like LinkedIn, Twitter and Jazz Pharmaceuticals.
“These types of companies need capital to grow,” he explains. “A lot of technology companies cannot go to the high-yield market, due to product obsolescence. So, for a fast-growing technology company, its only option may be equity or converts.”
In contrast, Spangler rarely sees consumer staples makers issuing convertibles. “Those companies are generating cash, so their desire for capital isn’t as great. They can grow internally with their cash flows.”
Stonehouse owns convertible bonds from Element Financial, which helps businesses finance equipment by providing loans outside of traditional banks. Transportation companies tend to be Element’s biggest borrowers. “It had a very strong quarter and the stock was up in the high single digits. The convertible bond yields were up in the mid-single digits.”
One reason for the strong financials is that, after several acquisitions, it’s become one of the largest lenders in its space. Element recently bought GE Capital’s trailer fleet services for $8.6 billion. “Management has several decades worth of experience,” says Stonehouse. “Valuation’s at a low double-digit earnings multiple—a little over ten times. Versus its peers, it’s trading at a meaningful discount. We think there’s substantial upside to the name.”
He doesn’t plan to convert to stock—in fact, he rarely does. “We’ll hold on to the convertible because we’re getting the gains just as if we held the stock—the convertible price is going up in lockstep with the stock.”
There are two reasons he’d consider converting: if he still wants to own the company, he’d convert to stock before the bond matures; or, if he needs the liquidity, he’d convert so he could sell the stock.
While Stonehouse has never had one of his names declare bankruptcy, he has had one that didn’t pan out the way he’d expected: NXP Semiconductors, a technology company he bought in early 2015. “They had quite a disappointing quarter. They didn’t achieve expectations with respect to sales and earnings. The stock was down 10%, 15%.”
What made him realize he’d have to exit was the management’s lack of confidence.
“Part of the frustration was there wasn’t an adequate explanation of whether their lines of business were on track going forward.” He lost about 10% when he sold the convertible bonds in Q4 2015.
And that’s why, he notes, it’s important to pay attention to a company’s balance sheet, credit rating and management before adding convertibles to your portfolio.
Advisors less bullish on equities
Canadian advisors are less bullish on North American equities than in Q4, according to Q1 surveys conducted by Horizons ETFs Management (Canada).
The two surveys asked advisors and investors about their return expectations for 14 asset classes. And, even though advisors are bullish on four classes (those are the S&P 500, NASDAQ-100, S&P/TSX 60 Index and S&P/TSX Capped Financials Index), the degree of optimism for each has declined since December.
Of the advisors surveyed, 71% said they were bullish on the S&P 500 heading into Q1, compared to 78% in the fourth quarter of 2015. Similarly, advisors’ sentiment for the NASDAQ-100 has fallen to 68% from 71% over the same period. As well, the number of advisors bullish on the S&P/TSX Capped Financial Index dipped to 54% from 62% because financials had relatively flat performance throughout Q4.
But, “advisors may see the banks as a value opportunity over the coming quarter. They are a source of dividend income for Canadian investors,” says Steve Hawkins, co-chief executive officer at Horizons ETFs.
He notes, “The decline of the Canadian dollar against the greenback has had a significant effect on U.S. equity returns, and advisors realize that an active currency hedging strategy can play a very important role in ultimate returns.” He suggests the Fed raising rates in December was likely a factor in boosting advisors’ sentiment at the end of Q4.
What’s surprising is sentiment for crude oil rose quarter-over-quarter between now and December, says the survey. The number of bullish advisors on crude oil rose to 45%, up from 39% last quarter, while the number of advisors that expressed bearish sentiment fell to 24% from 30%.
Similarly, the number of advisors bullish on the S&P/TSX Capped Energy Index also rose slightly to 40%, from 37% last quarter, while the number of bearish advisors remained flat at 33%. Overall the energy index declined slightly over the quarter by 2.41%, as at December 31, 2015.