Convertible bonds have a reputation for being a little geeky, only accessible for mathematicians. But as interest rates are starting to creep up, and equities being met with challenges, the adaptability of convertibles could make them a good asset for the year ahead.
What are convertible bonds?
Convertible bonds are fixed asset investments that can be converted into shares at a specified share price, preset at a premium over the existing share price by the issuing company. The conversion feature produces an equity upside, so the interest rate isn’t as high as a normal bond, but there is a coupon nonetheless. So, convertibles can move with the underlying share price, but also have a price below which they cannot fall due to their interest rate.
This hybrid of bond and equity can make convertibles a versatile and appealing vehicle for many investors. It essentially protects the initial investment on the downside but enables them to make the most of any potential upside.
What kind of returns can you expect?
In the past, convertible bonds have returned a similar amount to equities but with far less volatility. Of course, that sounds too good to be true, and yes, there are a couple of caveats. Bond yields and interest rates have steadily dropped for decades, helping bond floors to move upwards. The convertible market is also far smaller than equity markets, so it wouldn’t be possible to replace an entire portfolio of shares with convertibles.
That said, when interest rates go up and equities start to worry about how far this will go, convertibles come into their own in terms of the risk/return ratio. This is one of the reasons 2019 looks like a good time to explore them.
Making convertibles work for you in 2019
With the help of good management, you will be able to move between bonds, taking advantage of moves in the market. The same managers will have the scope to move around different regions of the world, or from one credit rating to the next, whilst making decisions about hedging or not hedging the bond’s underlying currency. This creates a number of variables for the active investment manager to play with. All in all, convertibles are definitely worth some exploring as you look to the year ahead.