There has been little in the way of relative strength in fixed income recently, one major exception to the weakness in fixed income has been convertible bonds
There has been little in the way of relative strength in fixed income recently. It has ranked at the bottom of the DALI asset class rankings for more than a year. Meanwhile, in the Asset Class Group Scores (ACGS) fixed income rankings, most of the groups that make up the US core sit in the red zone with scores below 2.5. One major exception to the weakness in fixed income has been convertible bonds. The convertibles group is the only fixed income group with a score north of 4.0 and has scored above that threshold for most of the last year.
Because they’re relatively complex and make up only a small part of the overall bond market, many people aren’t familiar with the particulars of how convertibles work. Convertible bonds are hybrid securities with features of both debt and equity. They give the bondholder the right to exchange the bond for a pre-determined number of shares of the issuer’s common stock. The owner of a convertible bond can profit from exercising the conversion option if the market price of the issuer’s stock is higher than the conversion price. The conversion price is the price at which the bond can be converted to common stock (e.g. a $1,000 par value bond redeemable for 50 shares of stock would have a conversion price of $20). In a situation where the underlying equity value of a convertible bond is higher than its conversion price the bond will generally trade much like equity, i.e., the price of the convertible bond rises and falls with the stock price.
Meanwhile, the value of the straight (option-free) bond acts as a floor to the value of the convertible bond, thereby making it less risky than a straight equity investment. Several methods for valuing convertibles exist. The most common and straightforward is the value of a straight bond plus the value of a call option on the issuer’s equity. Because the option to convert is an option to the bondholder, a convertible will have a lower yield than an otherwise equivalent straight bond.
It is also important to note that convertible bonds typically have a yield advantage over common shares. I.e. an investor earns more income from holding the convertible bond than they would receive in dividends from holding the common stock. This is one reason why a bond may not be immediately converted if the value of the underlying equity rises above the conversion price.
Because convertible bonds often trade more like equity than bonds, they often don’t exhibit the same sensitivity to interest rates seen in other types of bonds. The downside is that convertibles are often highly correlated to equities and therefore reduce the diversification benefit of a fixed income allocation.
If you are interested in adding convertibles exposure there are a few options. The two largest ETFs in the space are the iShares Convertible Bond ETF (ICVT) and the State Street Convertible Securities ETF (CWB). Currently ICVT has a notable relative strength advantage over CWB; ICVT currently shows a strong 5.35 fund score, while CWB has an acceptable, but significantly weaker 3.93 fund score. Because convertible bonds are heavily influenced by equity prices, the sector exposure of these funds can be just as important as in an equity ETF. ICVT’s largest exposure is technology, which makes up about 43% fund, followed by consumer cyclicals at around 14%, this is a potentially advantageous sector allocation given the strength of technology, which currently ranks at the top of the DALI sector rankings. However, for those utilizing relative strength strategies for their equity allocations (which are likely overweight technology) adding a bond fund with significant correlation to technology stocks will add to the diversification problems that convertibles present.
ICVT Sector Exposure
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Because convertibles are hybrid securities with features of both debt and equity. They can be a way to add strength to a fixed income portfolio in an environment that doesn’t favor traditional rate-sensitive bonds. However, because they often trade like equity they often exhibit more volatility than traditional bonds and can reduce the diversification benefit of a fixed income allocation.
