John Calamos explains how the hybrid characteristics of convertible securities provide strategic benefits through economic cycles, pairing higher yields and less interest rate sensitivity than fixed income with limited-risk equity exposure
As a bond with an embedded option, convertible securities can be thought of as providing the best of both worlds—the opportunity to participate when equities advance, combined with potential downside protection if equity markets decline.
Because of their hybrid-equity/fixed-income characteristics, convertibles may defy easy categorisation within traditional asset allocation frameworks. At Calamos, we utilise convertibles in many ways, including within lower-volatility equity, enhanced fixed-income, and alternative strategies.
In the case of a strategy that seeks lower-volatility equity participation, the convertible’s fixed-income characteristics (the bond floor and coupon income) can help smooth out periods of downside equity volatility. The appeal of a lower-volatility equity strategy may be especially strong for investors who want to participate in the equity markets but have been unsettled by the volatility that can accompany even rising markets.
Increasingly, we see institutional fixed-income investors look to convertible securities as a way potentially to insulate an asset allocation against rising interest rates. Because rising rates are typically associated with economic growth – a favourable backdrop for equities – the convertibles’ embedded option becomes more valuable to investors as rates rise. Just as convertibles lessen the temptation for the equity investor to time the stock market, convertibles may mitigate anxiety about positioning a portfolio ahead of eventual interest rate increases.
A proactive approach to interest rates is critical for several reasons. First, the ongoing expansion of the US economy coupled with the euro-zone’s continued progress toward recovery should ultimately lead to less accommodative global monetary policy.
Second, factors beyond monetary policy can move interest rates – including inflation, energy market shocks, and geopolitical uncertainty.
Finally, history has shown that when interest rates rise, they can ascend rapidly and catch investors by surprise.
Convertibles have performed more like stocks than bonds during rising-rate environments. For example, the figure shows the performance of US convertible securities, equities, and bonds during periods when the yield of the 10-year US Treasury bond rose more than 100 basis points. Due to their equity sensitivity, convertibles outperformed the fixed-income index in each time period, and even surpassed the S&P 500 index four times. Globally, convertibles have generally proven more resilient than bonds when interest rates have risen, as well.
Having invested in convertibles for more than 40 years, I strongly believe active management is essential for achieving the appropriate balance between equity and fixed-income characteristics for a given investment objective. Not all convertibles are created equal, varying in their levels of equity and credit sensitivity.
Over time, the equity and credit sensitivity of a convertible changes, and the overall convertible universe can also fluctuate significantly in regard to these characteristics. As a result, convertibles are particularly ill-suited to passive strategies.
Convertible issuance over recent years has been encouraging, as companies seek access to capital in an improving economy. We expect issuance to remain healthy as economic recovery continues but bank funding remains more restrained.
While convertibles’ fixed-income characteristics can provide resilience during equity market volatility, the equity sensitivity of the convertible provides the opportunity for participation in equity market upside, as well as a potential hedge against rising interest rates. As a result, actively managed convertible allocations can provide a compelling diversifier of a fixed-income allocation, providing income that has been less sensitive to duration risk.
Indeed, for investors who are equipped to understand and capitalise on the complexity of the convertible security through active management, there are significant opportunities over full and multiple economic and market cycles.
John Calamos is CEO and global Co-CIO of Calamos Investments
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Convertible bond performance: Best of both worlds