Concerned About Interest Rates Rising? Consider Convertibles

August 4, 2015

by Sponsored Content from Invesco

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Over the past few months, several major companies involved in the automotive, telecommunications, energy and other industries have issued convertible securities to help fund their business activities. Some investors may not be familiar with convertibles, but given their historical outperformance during times of rising interest rates, I believe now is the time for investors to peer under the hood and learn how convertibles work.

What are convertibles?

A convertible bond is a corporate bond that has the added feature of being converted into a fixed number of shares of common stock. They make up a small, but important, part of the capital markets.

The asset class weighs in with a market value of about $207 billion in the US, which is considerably smaller than the $1.35 trillion domestic high yield market.1 Yet convertible securities provide an important source of financing for companies. They are particularly used in the speculative corners of the technology and health care sectors, but they also provide funds for large-cap, “mainstream” corporations seeking to finance merger and acquisition activity, repay higher-cost debt obligations, or utilize for general corporate purposes.

Why consider convertibles?

The unique structure of convertible securities combines equity and bond features. Therefore, they can provide a measure of risk mitigation in equity-oriented portfolios due to their bond-like regular coupons and stated maturities, as well as their capital structure seniority relative to equities. For bond-focused portfolios, converts can provide the potential for price appreciation through their embedded equity call options.

What makes convertibles especially attractive today, in my view, is their historical performance during periods of rising interest rates. In fact, the table below shows that:

  • In each of the last 10 periods of rising interest rates in the US going back to 1989-1990, the performance of convertibles has exceeded that of US government bonds.
  • Converts also outpaced the returns of the high yield market in a majority of those timeframes.
  • They even outperformed the S&P 500 Index during almost half of those periods.

Thus, investors seeking an alternative to traditional fixed income in a rising rate environment may want to consider converts given their history of outperformance in those periods.

Interest Rates

What drives convertible performance?

There are several reasons behind these results.

  • Unlike non-convertible corporate or government debt, convertibles contain an equity component (usually a call option on the issuer’s stock) so that total returns are generated by their bond components (i.e., coupon, maturity, the perceived financial strength of the issuer and the level of seniority the security holds in the issuer’s capital structure) and their stock-like features as well.
  • Many converts are issued by companies in growth-type sectors such as technology, which are more likely to perform better during periods of economic expansion (when interest rates are most likely to rise).
  • Convertibles also tend to have shorter durations than non-convertible debt,2 mitigating the impact of rising interest rates on their valuations. That’s due to converts’ relatively short maturities (many are issued with five-year maturities) in addition to the imbedded put and call options in many convertible bonds, which effectively shorten the time they remain outstanding.

Talk to your advisor

For the first time in a while, investors are anticipating an environment of rising interest rates. Talk to your advisor to make sure your portfolio is positioned appropriately, and learn more about Invesco Convertible Securities Fund.

1 Source: Bank of America Merrill Lynch Lighthouse Analytics. Convertibles represented by the BofA Merrill Lynch All US Convertibles Index and domestic high yield represented by the BofA Merrill Lynch High Yield Broad Market Index.

2 Source: Bank of America Merrill Lynch Lighthouse Analytics. Duration of convertible market as per the BofA Merrill Lynch All US Convertibles Index is approximately 2.0 years, high yield market as per the BofA Merrill Lynch High Yield Broad Market Index is approximately 4.1 years, corporate high grade as per the BofA Merrill Lynch High Grade Broad Market Index is approximately 6.7 years.

Stuart Novick, CFA
Senior Analyst

Stuart Novick is a Senior Analyst working with the Invesco Convertible Securities team.

Mr. Novick joined Invesco in 2014 and entered the industry in 1989. He was previously a senior credit analyst at Bloomberg, covering special situations in the Bloomberg Industries research group. Prior to that, he was a credit analyst at the Financial Times Group. Mr. Novick started in the industry in 1989 and spent 17 years at Citigroup, where he was a director in the convertible securities group.

Mr. Novick earned a BS degree from the University of Albany and an MBA from Columbia Business School. He holds the CFA designation.

Important Information

The value of convertible securities may be affected by market interest rates, the risk that the issuer will default, the value of the underlying stock or the right of the issuer to buy back the convertible securities.

A basis point is one hundredth of a percentage point.

Duration, which measures the price sensitivity of a fixed income investment to interest rate changes, is the number of years it will take a bond’s cash flow to repay an investor the bond’s purchase price.

The Barclays U.S. Government Credit Index includes Treasuries and agencies that represent the government portion of the index, and it includes publicly issued US corporate and foreign debentures and secured notes that meet specified maturity, liquidity and quality requirements to represent the credit interests.

The BofA Merrill Lynch All U.S. Convertibles Index is an unmanaged index that measures performance of US dollar-denominated convertible securities not currently in bankruptcy with a total market value greater than $50 million at issuance.

The Barclays US Corporate High Yield Index is an unmanaged index considered representative of fixed-rate, noninvestment-grade debt.

The S&P 500® Index is an unmanaged index considered representative of the US stock market.

The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

NOT FDIC INSURED MAY LOSE VALUE NO BANK GUARANTEE

Before investing, investors should carefully read the prospectus and/or summary prospectus and carefully consider the investment objectives, risks, charges and expenses. For this and more complete information about the fund(s), investors should ask their advisors for a prospectus/summary prospectus or visit invesco.com/fundprospectus.

All data provided by Invesco unless otherwise noted.

Invesco Distributors, Inc. is the US distributor for Invesco Ltd.’s retail products and collective trust funds. Invesco Advisers, Inc. and other affiliated investment advisers mentioned provide investment advisory services and do not sell securities. Invesco Unit Investment Trusts are distributed by the sponsor, Invesco Capital Markets, Inc., and broker-dealers including Invesco Distributors, Inc. PowerShares® is a registered trademark of Invesco PowerShares Capital Management LLC (Invesco PowerShares). Each entity is an indirect, wholly owned subsidiary of Invesco Ltd.

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Concerned about interest rates rising? Consider convertibles by Invesco Blog

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