Rising interest rates and volatile markets can create headwinds for all types of investors. Franklin Equity Group’s Alan Muschott makes a case for convertible securities, a hybrid asset class that he thinks can adapt to various market conditions.
Amid expectations that US interest rate increases could accelerate, many fixed income investors in particular have asked for our view on the prospects for convertible securities. It’s an understandable concern as bonds tend to lose value when interest rates rise, and the Federal Reserve’s June projection called for a total of four increases in its benchmark interest rate this year.
As the chart below shows, during prior periods of rising interest rates, convertibles have performed better than 10-year US Treasuries. Therefore, in a rising-rate environment, we think convertibles can be a favorable place for fixed income investors to be.
That said, it’s a bit incomplete to compare the performance of convertibles to other fixed income investments given their characteristics. Convertibles are a unique asset class, offering investors features associated with bonds and the growth potential of common stocks.
Convertibles are generally structured as a form of debt (bonds, debentures) or preferred shares with an embedded option that allows conversion into common shares under predetermined conditions. That embedded conversion option provides capital appreciation when the underlying common stock rises.
In a rising-rate environment where interest rates are rising for the “right” reasons—for example, strong economic and corporate earnings growth—equities tend to perform well. If the underlying common stock in a convertible security rises with the market, it should also increase in value because of the conversion option.
Conversely, if the common stock doesn’t perform well, the debt features of the convertible—interest payments and claim on principal—may provide some support. In this respect, convertibles act similarly to bonds, with characteristics that can potentially offer less value erosion in declining markets than the underlying common stock.
Given the run we’ve seen in the US equity market over the past few years, many investors may be concerned about stock valuations and their equity exposures. In this environment, some investors may want to consider select exposure to convertible securities.
For those seeking income and risk-managed equity exposure, convertibles can offer numerous potential benefits, including:
Looking at opportunities across sectors, we see technology as increasingly becoming a non-discretionary expense for a wide range of companies and industries. In particular, we like certain convertibles in growth themes, like on-demand software.1
The bottom line is we think it’s a good time for investors to reconsider allocating to select convertibles. We believe convertible securities’ ability to adapt to myriad market conditions makes the investment class an attractive vehicle for increasing a portfolio’s diversification.2
All investments involve risks, including possible loss of principal. Generally, those offering potential for higher returns are accompanied by a higher degree of risk. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Investments in fast-growing industries like the technology sector (which historically has been volatile) could result in increased price fluctuation, especially over the short term. Bond prices generally move in the opposite direction of interest rates. Thus, as the prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of a portfolio may decline. High yields reflect the higher credit risk associated with these lower-rated securities and, in some cases, the lower market prices for these instruments. Convertible securities are subject to the risks of stocks when the underlying stock price is high relative to the conversion price (because more of the security’s value resides in the conversion feature) and debt securities when the underlying stock price is low relative to the conversion price (because the conversion feature is less valuable). A convertible security is not as sensitive to interest rate changes as a similar non-convertible debt security, and generally has less potential for gain or loss than the underlying stock.