Investing in hybrid bonds increases income and reduces some risks.
Summertime fun might include long cruises along the coast on a two-seat tandem cruise with a top-down cruise. As summer comes and goes and it’s time to pull out the sports car and put the top back up as cooler seasons and inclement weather approach, consider this: Convertibles can be used as an investment too, and they can offer more than just driving fun. A convertible bond, a hybrid investment, is always in style as part of any diversified all-weather investment portfolio.
Hybrid cars are all the rage with car buyers. Convertibles are perennial favorites of car enthusiasts. Both can be part of a long-term investment portfolio as well.
Convertible bonds may be unfamiliar to most investors but they are a great tool to help reduce risk in any investment portfolio. Convertible bonds are hybrid investment vehicles that offer the best of both worlds – income now like bonds and the potential to gain appreciation later like stocks.
They get paid while you wait
Convertible assets provide investors with a fixed return like any other bond. This regular income provides better downside protection than simply holding the stock. They also have a feature that allows the bondholder to trade in the bond for a certain amount of shares on a predetermined date. This feature makes these hybrid bonds useful during inflationary times when stock prices may rise and the value of other bonds may fall. During market corrections or bear markets, investors receive the benefit while waiting for the next recovery or bull market.
Like any other bond, there is an underlying credit risk to the issuer. The conversion opportunity also means that a convertible bond may track the underlying stock more closely and have higher volatility than a straight bond. However, the hybrid nature of this investment provides corresponding benefits to help offset these risks.
Convertible bonds are developing as a separate asset class
As an asset class, convertibles have been around for more than 150 years. From December 1973 through mid-2010, the convertible bond index had total returns (interest plus appreciation) of 2,736%, outperforming the government/corporate bond index by 943% and finishing higher than the high-yield bond (aka junk) index. 1585% (BofA/Merrill Lynch Convertible Research, 6/30/10).
Convertible bonds have evolved over time. In the past, many small companies that had no other means of accessing capital were issued. Over the past 15 years, convertible bonds have become more popular among companies with larger brands, and treasurers have added them to their mix of ways to fund companies without immediately disinheriting shareholders. They continue to be the go-to strategy for growing companies in the technology, pharmaceutical and bioscience sectors.
In the past, convertible bonds were more susceptible to large fluctuations in value because the window providing a conversion option was usually very far away. Many now offer relatively short conversion windows into stocks: 3 to 5 years, which reduces the holding period a bond investor needs to withdraw money and redeem their money with interest or equity gains.
Advantages of convertible bonds
During the Fed’s tightening, convertibles did quite well. It is inevitable that interest rates will rise from their historically low rates, with or without inflation. While the value of government bonds and other high-quality corporate bonds will suffer when interest rates rise, convertible bonds are more likely to retain their value, continue to pay interest and offer the potential for greater return when converted into stocks. (For a white paper detailing this, please visit http://www.ClearViewWealthAdvisors.com and post a request).
1. Higher yield than most stocks (currently >3.5%)
2. The possibility of capturing the estimate
3. Promote diversification and reduce potential risks resulting from low correlation with stocks and bonds
4. Proven track record of capital preservation
5. Unlike other bonds, convertible bonds have generally performed well during periods of Fed tightening to increase interest rates or periods of inflation.