Convertible Securities: Reason for Optimism in 2H 2018 and Beyond
Convertible securities may be less well known than stocks and bonds, but they offer many potential benefits. Convertibles combine characteristics of stocks and bonds; and with active management, they can enhance overall portfolio diversification and support multiple asset allocation goals. For example, convertibles can be used for lower-volatility equity participation and enhanced fixed income exposure. They can also be used within alternative strategies. (To learn more about how convertibles work, read our in-depth guide.)
Because of their versatility, we believe convertibles are best thought of as a strategic allocation to be held over full and multiple market cycles. However, the case for actively managed convertibles is especially strong today:
1. During the second half of the year, convertibles should benefit in advancing but volatile equity markets. The U.S. economic expansion continues, supported by an upbeat consumer, strong corporate earnings, contained inflation, deregulation and tax reform. Against this backdrop, there is more room for stocks to advance. At this point of the economic cycle, the prospects may be especially strong for growth-oriented and smaller-cap names, which are well represented in the convertible universe.
However, with mid-term elections, trade concerns, more normalized interest rates, and a higher level of global economic uncertainty, markets will be volatile in the short term. During downturns, convertibles can be more resilient than stocks because bond attributes (including coupon income) provide a floor. Alternatively, when equity markets rise, the convertible typically becomes more valuable (its embedded option can participate in equity upside).
2. Convertibles have outperformed bonds during rising rate environments. Thanks to their equity characteristics, convertible securities have performed well versus bonds during periods of rising interest rates—including this most recent period. Although we don’t expect interest rates to soar, we do expect the Federal Reserve to maintain its gradual tightening as the U.S. economy extends its growth phase. Over the past 25 years, there have been 11 periods when the yield of the 10-year U.S. Treasury rose more than 100 basis points. During every one of these periods, convertibles outperformed bonds.
Figure 1. Convertibles Have Outperformed Traditional Bonds When Interest Rates Rise
Returns in Rising Rate Environments
Performance data quoted represents past performance, which is no guarantee of future results. Current performance may be lower or higher than the performance quoted.