The time is ripe for investing in convertible bonds.
You may not have heard of them before, but these hybrid securities can help protect your wealth if interest rates rise or stock prices fall. Convertible bonds are fixed-income securities that can be converted into the stock of the company that issued the bond.
“They can make a lot of sense for investors who want to see some stock market upside but also want to receive a regular interest coupon payment,” says Brad McMillan, chief investment officer for Commonwealth Financial Network.
Convertible bonds pay a regular interest coupon, just like a bond, but if the stock of the issuing company does well, the owner of the bond can convert it into shares and make an even bigger profit.
[See: 8 Tips for Bond Investors Watching Rising Rates.]
Why do convertibles make sense now? Three reasons.
The first is the rising cost of borrowing money.
“From a fixed-income standpoint, a lot of investors are concerned about rising interest rates,” says Edward Silverstein, portfolio manager of the MainStay Convertible A fund in New York.
Bond prices and interest rates move in opposite directions. So if interest rates rise, as they are expected to continue doing, bond prices will fall.
Silverstein says investors have enjoyed decades of bond market gains as rates fell. Then, after the election last November, interest rates moved higher quickly.
“Technically a convertible is a bond, but the price is negatively correlated to rates,” Silverstein says.
For proof, look at how convertibles have performed compared to corporate bonds in the market since November. The iShares Convertible Bond exchange-traded fund (ticker: ICVT), which tracks an index of convertible securities, is up more than 10 percent through mid May while the PIMCO Investment Grade Corporate Bond ETF ( CORP), which tracks a basket of corporate bonds, is down less than 1 percent over the same period. The iShares ETF has annual expenses of 0.3 percent or $30 per $10,000 invested.
The second reason why convertible bonds make sense now is that investors are concerned about how pricey U.S. stocks have become.
“If equities do well, then convertibles do well,” because convertibles tend to participate in about 60 to 80 percent of stock market gains while only getting hit by about 50 percent of the losses, Silverstein says. The reason is simple: The coupons provide steady income, and that helps buoy the security’s price.
The third reason is that the market for convertible bonds is now thriving.
“Issuance [of new securities] has been pretty strong the last few years,” Silverstein says. “There was some concern after the financial crisis when there was little issuance.” Small markets tend to be unattractive to investors.
He says investors should expect between $30 billion and 50 billion of new convertibles to be issued each year. That’s important because 10 to 15 percent of the $190 billion market disappears each year and must be replenished with new issues.
[See: 10 Long-Term Investing Strategies That Work.]
How much is too much when it comes to convertibles? Finding the right balance of assets is one of the keys to successful investing. Most people know they need a heavy helping of stocks. But ask them the same question about convertibles and you may be met with a blank stare.
“Studies have shown that a 15 percent allocation to convertibles produces the most efficient portfolio, one with the highest risk-adjusted returns,” Silverstein says. In other words, that’s the sweet spot between a portfolio’s expected gains and its riskiness, or volatility, though Silverstein realizes many people won’t go that far.
A drawback with a potential benefit. There is a problem with convertibles that makes them different from buying a basket of stocks such as the Standard & Poor’s 500 index. Not all companies issue convertibles, and currently, the companies that have them outstanding are concentrated in two areas.
About four-tenths of the market is from technology and biotech, says Adam Kramer, portfolio manager of the Fidelity Convertible Securities Fund in Boston.
“Those two sectors have had very high growth and not a lot of debt outstanding,” he says.
Companies in these sectors, Kramer says, like convertibles because they can raise money without diluting the existing shareholders (at least not until the convertibles are converted into stock). Plus, the companies can get a more competitive interest rate than if they had issued a corporate bond.
The risk with all high-flying sectors is that sometimes they stop flying high and drop like a stone. Anyone who remembers the dot-com bubble and the bust that followed understands this all too well. And that may be yet another reason to invest in convertibles because if there is another technology bust, at least the convertible bonds will continue to pay a coupon.
[See: The Fastest Ways to Lose Money in the Stock Market.]
Also, the concentration of issues in biotech and technology won’t remain constant but will change over time, Kramer says. Five years from now, different sectors could dominate.
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Why You Should Buy Convertible Bonds Now originally appeared on usnews.com
