The convertibles asset class doesn’t typically lend itself to timing. Convertibles serve a purpose in a portfolio, as they have the potential to provide more of the upside and less of the downside of the underlying stocks due to their hybrid nature. However, increased new issuance and favorable deal structure terms do suggest an attractive entry point.
Through the end of March, U.S. convertible new issuance topped $19 billion and is on pace to hit $80 billion for the year. That would be the highest total since 2020 when U.S. issuance reached $106 billion, just short of the record. According to Bank of America, over 40% of issuance is for refinancing purposes, which may be reflective of the market’s acceptance of a higher-for-longer rate environment. The composition of that issuance is changing as well. Because of higher yields, there has been an increase in investment-grade convertible issuance since last year. In a low-rate environment, there was little incentive for higher-quality companies to seek financing in the convertibles market. (Coupons were already low, so there wasn’t much interest-savings potential). This is in sharp contrast to the pandemic-era, when the majority of deals were brought to market opportunistically by lower-credit-quality and younger companies.
Figure 1: Increase in larger, higher-quality issuers accessing the convertibles market
Source: BofA Global Research Data as of 3/7/24.
Additionally, the sector composition of the convertibles market has become more diverse since the pandemic. Just a few years ago, Technology and Healthcare accounted for well over 50% of the market — and now make up only 42% of the market. At the same time, Consumer Discretionary jumped from 5% to 15%. Consumer names in the market include Airbnb, Cheesecake Factory, DraftKings, Etsy, Topgolf, Shake Shack and Wayfair, to name a few. The three major cruise lines, as well as a number of airlines, are in the market. Automotive issuers include Ford, Rivian and Lucid. Uber and Lyft also have done deals in the last few months.
Figure 2: Moving beyond a Predominantly Tech & Healthcare Asset Class
Source: BofA, as of 3/8/24
Not only is the composition of the market evolving, but deal structures have also become more investor-friendly recently. Coupons have trended higher (Just a few years ago there was a large volume of zero-coupon convertibles being issued!) and are averaging over 3% this year. Initial conversion premiums have also been on a decline — conversion premiums refer to the amount a stock needs to appreciate for the convertible to be “in the money”. This suggests the asset class is well positioned for an asymmetric return profile — which is the rationale for the asset class.
Figure 3: New issuance coupons have trended higher…
Figure 4: ...While initial conversion premiums have declined
Source: BofA, as of 3/8/24
In 2023, equity performance was highly concentrated, with the “Magnificent 7” responsible for much of the S&P 500’s1 returns. These companies are not in the convertibles market, which explains why the market’s up-capture versus the S&P 500 was below average. However, for investors looking to diversify away from those names, an allocation to convertibles may be a way to maintain exposure to the equity markets in an asset class that seeks to mitigate downside risk. We believe that even though the argument could be made that there is no bad entry point into convertibles, given the evolution of the market, favorable deal terms and lack of Magnificent 7 exposure, now might be a particularly good time to consider convertibles.
1. The S&P 500® Index is widely regarded as the standard index for measuring large-cap U.S. stock market performance. It is not possible to invest directly in an Index.
About Risk: All investments are subject to market risk, including possible loss of principal.
Issuers of convertible securities may not be as financially strong as those issuing securities with higher credit ratings and may be more vulnerable to changes in the economy. Investing in below investment grade securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds. Foreign securities are subject to interest rate, currency exchange rate, economic, and political risks. These risks may be greater for emerging markets. Funds that invest in bonds are subject to interest-rate risk and can lose principal value when interest rates rise. Bonds are also subject to credit risk, in which the bond issuer may fail to pay interest and principal in a timely manner.
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