These threats can cause shifts in market sentiment and volatility, which can have negative impacts to investors despite improving conditions. Strategies that offer investors some continued upside potential but may protect more in a down market should be considered. One asset class we tend to favor in this type of environment is convertible bonds.
Convertibles bonds are hybrid securities, combining characteristics of both equities and traditional bonds, as each convertible bond is exchangeable for equity shares. As equity prices move upward, the value of the convertible bond moves up to a degree based on its conversion feature. This can lead to a healthy degree of equity sensitivity as equities move higher.
However, as equities sell off the convertible bond will fall, but generally will find support to the downside as it begins to be valued for its fixed income characteristics, such as the return of principal and interest payment.
As the chart above demonstrates, a convertible bond may go through different phases during its life depending on the underlying equity price and the conversion feature. When the underlying equity price is below the conversion price, the convertible will tend to act more like a debt security rather than equity. As the equity price increases, the bond’s value will also increase due to the conversion feature. As the underlying equity price converges with the conversion price, the investor enters a sweet spot where they are participating more in the equity upside, while also collecting interest payments. As the equity price continues to rise, more equity sensitivity is experienced. However, as equity prices fall, the bond finds support again as it re-enters the middle or defensive range where it is supported by the convertible’s fixed income features.
Recently, we have seen improving fundamentals and believe we will continue to see GDP growth in 2017. Job creation remains on a positive trajectory, as we have seen continued strength in jobless claims and income levels. This strength should lend support to consumer sentiment and spending.
Business sentiment is also optimistic. The Conference Boards’ U.S. Leading Index continues to improve and we are seeing continued growth in production. While all these factors should support equity markets, we remain concerned with volatility and downward pressure from several areas. Geopolitical risks are high as the U.S. has changed tone with the new administration on number of fronts. For example, recent strikes in Syria by the U.S. have strained U.S. and Russian relations further. North Korea continues to be problematic and the world will be adjusting to new trade negotiations, which could create tensions. Domestically, we are starting an internal battle between fiscal and monetary policy as the Fed raises rates and plans the suspension of reinvesting proceeds from maturing bonds, thus reducing the size of their balance sheet. Furthermore, there is uncertainty in the future of Fed policy as we prepare for a Fed regime change with the end of Janet Yellen’s term next February. Also, there is uncertainty surrounding the passing and timing of many fiscal policies aimed at supporting further U.S. economic growth through tax cuts, infrastructure spending, and the roll back of tedious regulations.
Walking a fine line between giving up potential equity upside from a strengthening economy and managing downside risks and volatility is challenging. We believe incorporating asset classes that offer some upside with a downside protection mechanism, such as convertible bonds, can be beneficial in this environment.
There are several ETF options in the space for investors looking to incorporate convertible bonds into their portfolio. The iShares Convertible Bond ETF (ICVT) tracks the Bloomberg Barclay’s U.S. Convertible Cash Pay Bond> $250mm Index, which isolates convertible bonds with issue sizes above $250mm. The Fund has an expense ratio of 0.20%. Similarly, the SPDR Bloomberg Barclays Convertible Securities ETF (CWB) is a passively managed strategy that is designed to track the Bloomberg Barclays U.S. Convertible Bond >$500mm Index. This option is restricted to larger issue sizes and has an expense ratio of 0.40%. Finally, for investors interested in active management, the First Trust SSI Strategic Convertible Securities ETF (FCVT) is managed by SSI Investment Management and has an expense ratio of 0.95%.
At the time of writing, Stringer Asset Management LLC (SAM) clients owned CWB. SAM is a Memphis, TN third-party investment manager and ETF strategist. Contact SAM at 901-800-2956 at firstname.lastname@example.org.
BofA Merrill Lynch U.S. Convertibles Index consists of convertible bonds traded in the U.S. dollar denominated investment grade and non-investment grade convertible securities sold into the U.S. market and publicly traded in the United States. The Index constituents are market value weighted based on the convertible securities prices and outstanding shares, and the underlying index is rebalanced daily.
Bloomberg Barclays U.S. Aggregate Index measures the performance of the U.S. investment grade bond market. The index invests in a wide spectrum of public, investment-grade, taxable, fixed income securities in the United States – including government, corporate, and international dollar-denominated bonds, as well as mortgage-backed and asset-backed securities, all with maturities of more than 1 year.
S&P 500 Index measures the performance of the large capitalization sector of the U.S. equity market and is considered one of the best representations of the domestic economy. Utilizing a market-cap weighting structure, this index invests in the 500 largest U.S. firms. All companies must have a 50% public float to be considered for inclusion in the benchmark.
The views expressed herein are exclusively those of Stringer Asset Management LLC (SAM), and are not meant as investment advice and are subject to change. Information contained herein is derived from sources we believe to be reliable, however, we do not represent that this information is complete or accurate and it should not be relied upon as such. All opinions expressed herein are subject to change without notice. This material does not constitute any representation as to the suitability or appropriateness of any security, financial product or instrument. SAM is not making any comment as to the suitability of any funds mentioned, or any investment product for use in any portfolio. There is no guarantee that investment in any program or strategy discussed herein will be profitable or will not incur loss. This information is prepared for general information only. Investors should seek financial advice regarding the appropriateness of investing in any security or investment strategy discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Investors should note that security values may fluctuate and that each security’s price or value may rise or fall. Accordingly, investors may receive back less than originally invested. Past performance is not a guide to future performance.