The first convertible security was issued in the 1850s by a railroad company in the United States and today we have had Amazon, Twitter and Tesla participating in this market. The reasons for issuance remains much the same; that is generally to fund high growth business operations. From an investor perspective, convertibles provide almost equivalent upside potential as stocks in bull markets while providing substantially greater downside protection during bear markets. This is evidenced by data, as since 1973, during up years the S&P returned approximately 15% while convertibles returned 13% and during down years the S&P averaged a negative 12% while convertibles returned a negative 5%. Today, we find ourselves in a unique situation as Jerome Powell finds himself between a rock and a hard place. If the highly anticipated rate cuts materialize and the FED is able to engineer an extension of this business cycle and hence extend this bull market, convertibles stand to participate in the gains. On the other hand, the “insurance” cuts could be perceived negatively by the markets on the basis that this cycle is about to end and with an outlook for slower growth and subdued inflation, we might witness another material correction in stocks similar to last December but without the rebounding pop, in which case convertibles stand to provide better downside protection. With approximately $ 400 B of convertibles outstanding in the global marketplace, rigorous bottom-up credit research should be conducted while selecting securities to ensure the downside protection remains in play, the key factor that gives this sector such an attractive risk/reward ratio.

Current Market Characteristics: The US has historically and continues to dominate the convertible market in terms of issuance and securities outstanding, accounting for 60% of the global market. 2018 saw an increase in new issuance in the US to US$ 51 Bn after averaging around $37 Bn for the 3 years prior. Since the financial crisis, the market has seen a more fundamental structural shift towards securities being issued with shorter maturities and longer call protection periods, a positive development from the perspective of investors. The graph below shows the current valuation of the market. (Graph Source: Calamos)

A case for convertibles in your portfolio: The characteristics of convertible bonds gives it the unique properties of having the ability of participating in the upside while providing protection to the downside, providing diversification benefits within a single security! Empirical evidence shows that adding convertibles to a multi asset class portfolio of equities and bonds, improves the efficient frontier, resulting in a higher risk adjusted return or Sharpe ratio.

Ratings of Convertible Bonds: While 60% of the market is unrated, this doesn’t necessarily imply poor or junk quality. Factors such as cost of the rating process will often result in the issuer forgoing the process. However, this signifies the importance of fundamental credit research of the company when selecting convertible securities.