After some relatively quiet years, convertible bonds are receiving a great deal of attention amid 2020’s volatile markets. The renewed interest and issuance means more choice and greater liquidity. What are convertible bonds and why do they deserve more attention from investors?
As their name suggests, convertible bonds are bonds that can be converted—generally at the investor’s option—into the issuer’s stock. The question is why they don’t form a bigger portion of the average portfolio, since they offer a desirably asymmetric upside/downside profile. Per the above, convertible issuance has been relatively low since the global financial crisis but started picking up significantly in 2019 and has been a huge beneficiary of recent market conditions. The increased volume of convertible activity has created a new opportunity set for both equity and fixed-income investors.
The convertible trade-off: two-thirds of the upside, one-third of the downside
Convertibles are often said to offer the best of both worlds, as they tend to have characteristics of both bonds and stocks. In stock-return terms, convertibles are thought to offer two-thirds of the upside potential of stocks with one-third of the downside.¹ That’s because, over time, convertibles have provided competitive returns with equities² while keeping one key advantage—the likelihood of principal repayment if the issuer remains solvent.³ Of course, the reality for investors is more of a trade-off.
Convertibles are essentially equity-enhanced bonds, which make them both an anchor of capital preservation and a kind of fuel for growth acceleration. They offer income, though typically much less than what’s available from traditional bonds and the likelihood of the return of capital. In exchange for the coupon, investors effectively buy the underlying shares at a premium to the current price. Convertible investors like to say they get “paid to wait.” For their patience, convertible investors may receive capital appreciation if the convertible follows the stock upward.
Don’t convert early
A common misconception is that investors convert their convertible securities as soon as the underlying shares exceed a bond’s conversion price (determined by the number of shares into which it can be converted). For example, a convertible bond with a face value of $1,000 that’s convertible into 40 shares of stock would have a conversion price of $25, but this doesn’t mean investors convert as soon as the stock exceeds $25. Typically, investors usually convert only when they’re forced to by a bond’s maturity or a call by the issuer. Investors don’t convert earlier because the bonds maintain some premium, as we’ve seen, even as the stock rises. Converting into stock means relinquishing that premium.
For example, if a bond’s conversion price is $25 and the stock is trading at $30, the bond would have conversion value of 40 shares times $30 per share or $1,200 per $1,000 face amount, more typically quoted as 120% of par or just 120. (The bond would typically have been issued at par with the stock around $18, where conversion value would be 72%.) But with the stock at $30, the convertible might, depending on its coupon and how much time remained until maturity or call, trade at a premium to 120, perhaps by as much as 15% to 25% or even more. Notice that the stock’s increase from $18 to $30 represents a gain of 67%. A 20% conversion premium above 120 would put the convertible at 144. The convertible’s gain of 44% would be two-thirds of the stock’s return, or a delta of about 66%.
The premium represents the remaining downside protection (essentially insurance) in the convertible. If the stock should fall back below the conversion price at maturity with the company remaining solvent, the convertible holder may ultimately choose not to convert into shares but to receive the bond’s par value. Therefore, if a convertible has appreciated in value with a rise in the underlying stock, it’s almost always wiser for a holder seeking to crystallize the gain to sell the convertible and capture the remaining premium than to convert into stock and then sell the shares.
1 Newly issues convertibles typically have a “delta,” or participation rate with the underlying stock, of 60% to 80%, while the fixed-income status acts as a shock absorber for prolonged downside moves in most cases. 2 While investment-grade and high-yield bonds have lagged the S&P 500 significantly over the past 50 years, convertible bonds have closely tracked the index's upside, with an annual return of 9.57% since 1987 compared with 10.62% for the S&P 500, according to Advent Capital. Barron’s, 12/3/19. 3 The average convertible default rate from 2003 to April 2018 was 1.2% versus 3.4% for high yield. Barclays, April 2018.