Convertibles are hybrid debt instruments issued by companies which have an option to convert into ordinary shares. What makes them stand out is that they combine the relative safety of bonds and the potential upside of shares.

Convertible bonds can be an attractive option for investors looking to supplement their income without sacrificing growth and those looking to adopt a slightly more defensive or cautious approach while still having some level of exposure to shares.

The size of the market is around $500 billion according to Brendan Ryan, senior research analyst at Aviva Investors. Although that might sound big, it is tiny compared with the global traditional corporate bond market which is around $8 trillion.

The Refinitiv Global Focus index is a good proxy for the market and comprises around 275 issuers, the bulk of which are US mid-cap growth companies.

Typically, convertibles have a shorter duration (average lifespan) than corporate or government bonds with an average duration of two-to-three years. This means they are less sensitive to interest rates.

HOW DO CONVERTIBLES PERFORM COMPARED TO SHARES AND BONDS?

Given their hybrid characteristics, you might expect convertibles to perform similarly to the broad stock market but with less downside risk.

Ryan of Aviva says a typical long-only balanced convertible strategy is looking to capture between 60% and 75% of the equity upside and around 40% to 50% of the downside.

However, 2022 has been a difficult year for bonds and shares as global interest rates have spiked in the face of surging inflation.

Convertibles have benefited from their lower duration which has limited their fall to 9% on average compared with 20% for the Bloomberg Aggregate Bond index and 20% for the S&P 500 stock index.

Over longer periods convertibles have performed well. According to data provider Morningstar: ‘Over the trailing 15 years through October 2020, the typical convertible-bond strategy notched a healthy 8% (annual) gain, which was on par with the average large-cap equity fund.

‘This return was a couple of percentage points ahead of the high-yield bond category average and nearly double the result of the intermediate core bond category norm.’

WHY DO COMPANIES ISSUE THEM?

Generally, convertibles are more flexible than traditional bonds. They have the advantage of being cheaper and speedier for companies to issue because they are not rated by credit rating agencies.

They are cheaper because of the intrinsic value attached to the equity option. Ryan explains that convertibles are the only security available which allow companies to monetise the volatility of their share price.

More volatile (unstable) shares have a greater option value because they are just as likely to gain 50% over the next few months as fall 50%.

This increases the likelihood of a convertible reaching its conversion price. The higher the option value, the lower the coupon a company might need to pay.

Convertibles are often issued for specific investment projects which have a finite life and payback expectation.

A good example illustrating the flexibility of investment product is the $1 billion convertible issued by chip maker Nvidia (NVDA: NASDAQ) in 2013, explains Ryan.

The company had around $3 billion of cash trapped overseas which it couldn’t tap to buy back its shares. The company was very cash generative, had no debts, but its shares were volatile, so the company proceeded to monetise the volatility by issuing a convertible.

Issuing convertibles also means avoiding equity dilution, although if the business is successful, convertibles merely delay dilution in the medium term. Dilution refers to the increased number of shares which reduces the earnings and dividends allocated to each individual share.

The price of a convertible bond tends to trade close to its correct price because of the actions of arbitrageurs who look to profit from any mispricing.

The goal is to consistently make money regardless of market direction while keeping volatility low. Often leverage is used to magnify returns but these types of investments are not suitable for retail investors.

HOW TO INVEST IN CONVERTIBLES

There are also challenges for retail investors looking to invest in traditional individual convertibles.

First, the convertibles market is not very liquid and dealing spreads can be very wide compared with trading in shares. Second, the minimum investment size can be prohibitively expensive, running up to hundreds of thousands of pounds or euros in the UK and Europe compared with only $1,000 in the US. Therefore it’s easier to invest via a fund.

One example is Aviva Investors Global Convertibles Fund (B3N12K4) which has an ongoing charge of 0.85% a year.

The £267 million fund has delivered returns of 91.5% and 30.7% over the last 10 and five years respectively, handsomely beating the benchmark returns of 74.2% and 14.7%.

An alternative option is to invest in an exchange-traded fund which tracks an index of convertible bonds. For example, SPDR Refinitiv Global Convertible Bond ETF (GCVB) has exposure to convertible bonds issued by the likes of cybersecurity group Palo Alto Networks (PANW:NASDAQ) and car maker Ford (F:NYSE).

HOW DO CONVERTIBLE BONDS WORK?

Convertibles pay semi-annual interest like traditional bonds based on the coupon rate. A bond with a 5% coupon will pay £5 per £100.

An important concept is the conversion ratio which determines the number of shares received on conversion of the bond.

For example, a five-to-one ratio means a bond will convert into five shares. The conversion price is the face or par value of the bond divided by the number of shares for which it exchanged. In the example above it would be 100/5 or £20.

The conversion price is usually set above the prevailing share price. The difference is known as the conversion premium.

In the example above, if the stock appreciates beyond £20, it makes sense to convert the bond into shares unless the holder believes the shares will move even higher.

In practice, balanced convertible fund managers are more likely to take profit in a convertible when the share price has moved to within 80% or 90% of the conversion price.

The reason is that as the share price approaches the conversion price the bond behaves more like a pure share. Fund managers typically sell and recycle the cash into other convertibles with more appreciation potential.

If the share price remains below the conversion price the holder would hold the bonds until maturity, collecting the coupons along the way and the principle at maturity.

Convertibles trading significantly below the conversion price are referred to as ‘busted’. 

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