Convertible securities are hybrid investments that can behave like stocks or like bonds.
Three types of converts
Convertibles can be considered equity-sensitive, balanced, or credit-sensitive.
While we continue to invest in balanced convertibles, we now see more opportunities in credit-sensitive converts
Convertible securities are hybrid investments that can behave like stocks or like bonds. Given the recent decline in stock prices, how has that impacted the opportunities we’re finding in the market?
Three categories of convertibles
Convertible securities contain a bond and a call option on an underlying common stock. Given where that underlying stock trades relative to its pre-stated conversion price, the convertible itself can be considered equity-sensitive, balanced, or credit-sensitive. Investors can utilize the different attributes associated with each type to achieve a targeted level of risk.
- Generally speaking, convertibles will become more equity-sensitive as the stock’s price moves further above its conversion price.
- Convertibles tend to trade more like a bond (credit-sensitive) as the stock’s price declines further below the conversion price. Credit-sensitive convertibles exhibit less equity sensitivity and more bond-like characteristics such as higher yields, higher conversion premium, and less downside risk relative to the common stock.
- In the middle are balanced converts, which possess both fixed income and equity attributes. This can provide investors with some downside support from the security’s bond floor, and some upside participation from its embedded call option.
Finding more bond-like opportunities
The stock market pullback has also caused a shift in the profile of the convertible market itself as the percentage of converts that are more credit-sensitive has grown from approximately 14% one year ago to a recent 43% according to Barclays.2 And nearly all that increase has come from the shrinking equity-sensitive portion of the market (54% one year ago to a recent 28%).2
While we continue to invest in balanced convertibles, which still make up about 1/3 of the universe, we now see more opportunities in credit-sensitive converts, which we believe are likely to move much less than their underlying stocks and provide yields in excess of those in the overall convertible universe.
Higher yields and shorter maturities
The average yield to maturity/put for all US convertible issues has climbed to 5.3% from 2.1% a year ago, due to a combination of lower security prices as rates have increased, higher coupons on newer issues and a decline in stock prices.3 Meanwhile, the comparable yield for the credit-sensitive U.S. convertibles basket is up to 7.7% compared to 4.6% a year ago.4
Additionally, we believe the shorter-term maturities of convertibles may be an advantage in today’s market. Most convertibles are issued with just five-year maturities and many contain call and/or put features, making their effective lives even shorter than that. The duration for the convert market is currently 2.3 years, compared to 4.2 years for the high yield market and 6.8 years for investment grade debt, according to Bank of America data.5 All else equal, the shorter duration of convertibles helps alleviate credit concerns to some degree, providing an added degree of comfort in investing in credit-sensitive convertibles.
Regardless of the market environment, our team is focused on what we believe is the best opportunity in the convertible universe –issues that may offer both upside participation should their underlying stocks rise and may offer downside support via the securities’ fixed income attributes. We are selectively adding credit sensitive bonds to the portfolio, which we believe may provide worthwhile returns and downside protection at lower prices, while offering attractive yields.
- 1Source: BofA Merrill Lynch as of 10/1/22
- 2Source: Barclays Research reports dated 10/1/21 and 9/23/22
- 3Source: Barclays Research data as of 9/23/22
- 4Source: Barclays Research reports dated 10/1/21 and 9/23/22
- 5Source: BofA Merrill Lynch as of 10/1/22
Originally Posted October 28, 2022 – How the stock market pullback has reshaped convertible opportunities
This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional before making any investment decisions.
All investing involves risk, including the risk of loss. Past performance is not a guarantee of future results.
Diversification does not guarantee a profit or eliminate the risk of loss.
The investment techniques and risk analysis used by the Fund’s portfolio managers may not produce the desired results.
Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating. Junk bonds involve a greater risk of default or price changes due to changes in the issuer’s credit quality.
Derivatives may be more volatile and less liquid than traditional investments and are subject to market, interest rate, credit, leverage, counterparty and management risks. An investment in a derivative could lose more than the cash amount invested.
A decision as to whether, when and how to use options involves the exercise of skill and judgment and even a well conceived option transaction may be unsuccessful because of market behavior or unexpected events. The prices of options can be highly volatile and the use of options can lower total returns.
Preferred securities may include provisions that permit the issuer to defer or omit distributions for a certain period of time, and reporting the distribution for tax purposes may be required, even though the income may not have been received. Further, preferred securities may lose substantial value due to the omission or deferment of dividend payments.
The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.
The Fund is subject to certain other risks. Please see the current prospectus for more information regarding the risks associated with an investment in the Fund.
Convertible securities may be affected by market interest rates, issuer default, the value of the underlying stock or the right of the issuer to buy back the convertible securities. Investments in convertible securities are subject to the risks associated with both fixed-income securities, including credit risk and interest rate risk, and common stocks. Convertible securities may have lower yields because they offer the opportunity to be converted into stock and if the stock is underperforming and the bond does not convert then the bond may have a lower return than a non-convertible bond.
A convertible security is an investment that can be changed into another form, such as convertible bonds that can be changed into common stock.
A put option gives an investor the right to sell a security at a specified price within a certain time frame.
A call option gives an investor the right to buy a security at a specified price within a certain time frame.
Yield to put and call: the total return on a bond that has an embedded put option to sell it back to the issuer if the puttable bond is held until the earliest permissible date when the put option can be exercised at a fixed price – typically at face value.
Yield to maturity is the percentage rate of return for a bond assuming that the investor holds the asset until its maturity date. It is the sum of all of its remaining coupon payments. A bond’s yield to maturity rises or falls depending on its market value and how many payments remain to be made.
Duration is a measure of the sensitivity of the price of a bond or other debt instrument to a change in interest rates. In general, the higher the duration, the more a bond’s price will drop as interest rates rise (and the greater the interest rate risk).
The ICE BofA US Convertible Index is an unmanaged index that measures performance of US dollar-denominated convertible securities not currently in bankruptcy with a total market value greater than $50 million at issuance.
The opinions referenced above are those of the author as of Oct. 3, 2022. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.
This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial advisor/financial consultant before making any investment decisions. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.
NOT FDIC INSURED
MAY LOSE VALUE
NO BANK GUARANTEE
All data provided by Invesco unless otherwise noted.
Invesco Distributors, Inc. is the US distributor for Invesco Ltd.’s Retail Products and Collective Trust Funds. Institutional Separate Accounts and Separately Managed Accounts are offered by affiliated investment advisers, which provide investment advisory services and do not sell securities. These firms, like Invesco Distributors, Inc., are indirect, wholly owned subsidiaries of Invesco Ltd.
©2022 Invesco Ltd. All rights reserved.
Before investing, carefully read the prospectus and/or summary prospectus and carefully consider the investment objectives, risks, charges and expenses.
Disclosure: Interactive Brokers
Information posted on IBKR Traders’ Insight that is provided by third-parties and not by Interactive Brokers does NOT constitute a recommendation by Interactive Brokers that you should contract for the services of that third party. Third-party participants who contribute to IBKR Traders’ Insight are independent of Interactive Brokers and Interactive Brokers does not make any representations or warranties concerning the services offered, their past or future performance, or the accuracy of the information provided by the third party. Past performance is no guarantee of future results.
This material is from Invesco and is being posted with permission from Invesco. The views expressed in this material are solely those of the author and/or Invesco and IBKR is not endorsing or recommending any investment or trading discussed in the material. This material is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the extent that this material discusses general market activity, industry or sector trends or other broad based economic or political conditions, it should not be construed as research or investment advice. To the extent that it includes references to specific securities, commodities, currencies, or other instruments, those references do not constitute a recommendation to buy, sell or hold such security. This material does not and is not intended to take into account the particular financial conditions, investment objectives or requirements of individual customers. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.
In accordance with EU regulation: The statements in this document shall not be considered as an objective or independent explanation of the matters. Please note that this document (a) has not been prepared in accordance with legal requirements designed to promote the independence of investment research, and (b) is not subject to any prohibition on dealing ahead of the dissemination or publication of investment research.
Any trading symbols displayed are for illustrative purposes only and are not intended to portray recommendations.