2020 was a crazy year for investors, and convertible securities had an especially wild ride. From the beginning of the sell-off on Feb. 20 to their low point on March 23 of 2020, the ICE BofA US Convertibles Index had declined by roughly 26%.1 After that dramatic – and brief – sell-off, convertible returns rebounded sharply, and the index was actually up 15% by the end of April from the March low. 1 And performance has continued to improve since then – the ICE BofA US Convertibles Index climbed by more than 46% in 2020, from Jan. 1 through Dec. 31. That puts the asset class in rarified air, trailing only the return on the NASDAQ 100 Index among the major equity and fixed income indices.1
What’s driven convertibles’ performance?
Recall that convertible securities are corporate bonds that have the ability to be converted into a fixed number of shares of the issuer’s common stock. In large measure, convertibles’ 2020 gains were fueled by the strong returns posted by the underlying stocks of issuers in technology and health care.2 An additional boost has come from a number of recent convert issuers whose businesses were significantly impacted by the pandemic – travel-related companies like airlines, ride hailing and cruise ship companies, retailers and restaurants, to name some – and have had sharp gains in their stock and convertible prices since the spring.
In addition to, and in part because of those gains, the convertible market in the US had record-setting new issuance in 2020. Over $113 billion in new paper came from what we would refer to as its core constituent participants – technology and health care companies – and also from those previously mentioned companies most impacted by the pandemic, which sought out balance-sheet-firming capital to ride out the current period of little-to-no revenue generation.3 Indeed, converts from consumer discretionary sector issuers – many in that significantly impacted category – had comprised just 8% of the US convertible universe at the end of 2019 but now make up 18%.2 Adding up the returns and the issuance, the size of the US convertible market has expanded from $212 billion at the end of 2019 to $325 billion as of the end of November 2020, growth of over 50%.2
More broadly, issuance in 2020 has also been the result of the low interest rate environment and high stock volatility. Those attributes have enabled convert issuers to raise money on very attractive terms, and many issuers are using proceeds to refinance previously existing higher-cost debt or pursue earnings-accretive acquisitions, among other things.2
Do converts still make sense?
Given the returns, the issuance and the attention the asset class has gotten in the financial media, it’s not surprising that our team has received a large number of inquiries about convertibles in general and Invesco Convertible Securities Fund in recent months. In addition to questions about what has driven the returns and record issuance in 2020, one other key topic we’re addressing is does it still make sense to invest in converts? We think the answer is yes and three reasons come immediately to mind:
- First, the asymmetric return profile of converts may allow investors to participate more in the upside in their underlying stocks than in their downside due to the converts’ fixed income floor.
- Second is the yield advantage that converts have had relative to their underlying stocks. According to data from Bank of America Merrill Lynch, that figure is currently around 90 basis points. And while that’s not a big number by historical standards, in an environment where 10-year Treasuries have been yielding less than 1%, it’s significant.
- Third is converts’ historical outperformance during periods of rising interest rates. We’ve talked about this one for a long time, and while rates have continued lower, they will eventually start to rise. Compared to non-convertible fixed income, converts have outperformed during periods of rising rates given their equity component and their relatively short duration relative to both investment grade and high yield bonds.
To sum up, 2020 was a very good year for convertibles from both an issuance and a return perspective. That said, we continue to see positives ahead as we move into 2021.
1 Source: ICE Data Services
2 Source: Bank of America Merrill Lynch, November chartbook
3 Source: Barclays CB Insights
Blog header image: Bonninstudio/ Stocksy
The ICE BofAML US Convertible Index tracks the performance of US-dollar-denominated convertible securities that are not currently in bankruptcy and have total market values of more than $50 million at issuance.
The S&P 500® Index is an unmanaged index considered representative of the US stock market.
An investment cannot be made directly in an index.
Convertible securities may be affected by market interest rates, the risk of issuer default, the value of the underlying stock or the issuer’s right to buy back the convertible securities.
An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.
Derivatives may be more volatile and less liquid than traditional investments and are subject to market, interest rate, credit, leverage, counterparty and management risks. An investment in a derivative could lose more than the cash amount invested.
The risks of investing in securities of foreign issuers, including emerging markets, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.
Junk bonds involve a greater risk of default or price changes due to changes in the issuer’s credit quality. The values of junk bonds fluctuate more than those of high quality bonds and can decline significantly over short time periods.
Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa.
Preferred securities may include provisions that permit the issuer to defer or omit distributions for a certain period of time, and reporting the distribution for tax purposes may be required, even though the income may not have been received. Further, preferred securities may lose substantial value due to the omission or deferment of dividend payments.
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The opinions referenced above are those of the author as of Dec. 29, 2020. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.
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