Understanding Recent Convertible Market Performance
Historically, U.S. convertible securities have offered an attractive risk/return profile. From 1988 through 2021, the ICE BofA U.S. Convertible Index captured about 80% of the upside and 60% of the downside of the average rolling 12-month returns of the S&P 500, NASDAQ Composite, and Russell 2000 indices.1 Even when the S&P 500 exceeded or declined by more than 10% in any given quarter, convertibles continued to exhibit asymmetric returns relative to equities (Figure 1). Recent relative performance has been weaker. In 2021, the three equity indices rose 28.7%, 22.2%, and 14.8%, respectively, for a 21.9% average return; the convertible index returned 6.3%, or 29% of the equity indices’ average. Year-todate through April 2022 downturn, the average return for these three equity indices was (16.9)%, while convertibles returned (12.1)%, participating in about 72% of the decline.
Figure 1: Asymmetric Returns for Convertibles 1988-20212
Convertibles had particularly poor performance relative to the S&P 500 for several reasons (Figure 2). The best performing sectors in the S&P 500, such as Energy and Materials, have a very low representation in the convertible benchmark. In addition, the mega cap companies that performed exceptionally well in 2021, such as Apple, Microsoft, and Alphabet, have no representation at all in the convertible market.
Convertibles Look Attractive vs. Other Debt Instruments
We think investors should view convertibles as an alternative slice of their bond allocation. Unlike straight bonds. convertibles historically have a negative correlation to interest rates, because convertible bond performance is largely driven by the performance of the issuer’s equity. In periods when interest rates and inflation rise, equities tend to advance in tandem with corporate profits. Also, convertibles do not necessarily mature at their nominal $1,000 par value. If the underlying equity rises above the bond’s conversion price, the bond can be converted into cash or common stock worth more than the bond’s par value. Owning a fixed-income security with performance relatively independent of interest rates and with capital appreciation potential may be an advantage in the current market environment (Figure 3 below and Figure 4 on the following page).
The sharp selloff in the stocks of many companies in 2021 that had recently issued convertible bonds has created an attractive opportunity for convertible investors, in our view. Many of these bonds are now trading below 90, in some cases very close to their theoretical bond floors, and many offer yields to maturity of 2% to 7%. These bonds are not “busted,” (their imbedded call options are not worthless), so there exists the capital appreciation potential if the underling share price recovers. For example, the convertible bonds of a game developer were trading near 90 recently. When the issuer announced it was being acquired, the bonds rose to 102.
Convertible bonds trading close to their theoretical bond floors pose relatively little downside risk, unless the company becomes financially distressed or interest rates rise significantly. Since most of these convertible securities are notes that mature in two to five years, their interest rate risk is relatively low. One downside, however, is that most of these instruments were issued with minimal cash coupons and their current cash yields are generally very low or nonexistent, even if their yields-to-maturity are attractive.
Adding convertible bonds to a traditional fixed income portfolio also offers the benefit of exposure to sectors, such as Information Technology and Healthcare, with large weightings in the convertible universe but little or no weight in most fixed income benchmarks.
While convertible bonds are usually the most volatile of fixed income securities, recent market dynamics may give investors an opportunity to capture potential favorable returns relative to other debt instruments.
MacKay’s Approach to US Convertibles
Since it’s inception, MacKay’s Convertible team has sought long-term fundamental value in actively managed portfolios. We largely own securities that we believe offer a measure of downside protection, issued by companies with strong business models whose underlying equities trade at reasonable valuations based on prospective free cash flow. The strategy generally has not fared well in speculative environments, when momentum and hype drove convertible performance. Fortunately, such markets are infrequent and generally short-lived: They have prevailed at least twice in the last quarter century, in the late 1990’s and in 2020. Our strategy’s relative performance was poor in both periods, and rebounded when the market corrected.
In 2000, the MacKay Convertibles strategy returned 3.8% after fees and 4.3% gross, while the convertible index returned (10)%. In 2021, the MacKay Convertibles strategy outperformed in each quarter, generating an annual return of 9.7% after fees and 10.3% gross, while the Convertible Index returned 6.3%.3 Relative to peers, the strategy was top quartile for one-year returns.4
We don’t expect a correction ahead comparable to 2000, but we do think the market is likely to continue to favor securities with sound fundamentals and reasonable valuations when interest rates are no longer kept near zero and crowds of online speculators no longer divorce a company’s share price from its earnings prospects. We believe our strategy’s strong results in 2021 demonstrate the soundness of our investment approach in a market where valuations once again matter.
1. Based on internal calculations comparing the rolling 12-month returns of the ICE BofA U.S. Convertible Index with the equal weighted average of the S&P 500, NASDAQ Composite, and Russell 2000 indices between 1988-2021.
2. Percentage capture determined based on average quarterly returns. Average quarterly returns calculated based on the relevant asset class’ performance in each calendar quarter where the S&P exceeded +10% or declined more than (10)%.
3. Please see the GIPS-compliant composite performance page in this document for additional performance information and disclosures.
4. Based on eVestment’s US Convertible Bond Universe.
The Convertible Composite includes all discretionary convertible accounts managed with similar objectives for a full month, including those accounts no longer with the firm. This strategy primarily consists of convertible securities such as bonds, debentures, corporate notes, and preferred stocks or other securities that are convertible into common stock or the cash value of a stock or a basket or index of equity securities. The strategy may invest in debt securities that are rated investment grade and below investment grade or, if unrated, that we determine to be of equivalent quality. Gross-of-fees composite performance reflects reinvestment of income and dividends and is a market-weighted average of the time-weighted return, before advisory fees and related expenses, of each account for the period since inception. Net-of-fees composite performance is derived by reducing the quarterly gross-of-fees composite returns by 0.125%, our highest quarterly fee. Policies for valuing investments, calculating performance, and preparing GIPS reports are available upon request. GIPS® is a registered trademark of CFA Institute. CFA Institute does not endorse or promote this organization, nor does it warrant the accuracy or quality of the content contained herein. Performance is expressed in US Dollars. The composite inception date is 1/1/90. The composite creation date is 1/1/01. All portfolios in the composite are feepaying portfolios. There can be no assurance that the rate of return for any account within a composite will be the same as that of the composite presented. Past performance is not indicative of future results.
MacKay Shields LLC, an SEC-registered investment adviser, claims compliance with the Global Investment Performance Standards (GIPS®) and has prepared and presented this report in compliance with the GIPS standards. The firm has been independently verified from January 1, 1988 through December 31, 2020. The verification report is available upon request. A firm that claims compliance with the GIPS standards must establish policies and procedures for complying with all the applicable requirements of the GIPS standards. Verification provides assurance on whether the firm's policies and procedures related to composite and pooled fund maintenance, as well as the calculation, presentation, and distribution of performance, have been designed in compliance with the GIPS standards and have been implemented on a firm-wide basis. Verification does not provide assurance on the accuracy of any specific performance report. A list including composite descriptions, pooled fund descriptions for limited distribution pooled funds, and broad distribution funds is available upon request. The primary benchmark for this composite is the ICE BofA All Convertibles Index. The CS First Boston Convertible Index was the primary benchmark for this product until 1/1/05. It was removed because CS First Boston ceased publication of this index. Indices do not incur management fees, transaction costs or other operating expenses. Investments cannot be made directly into an index. The ICE BofA All Convertibles Index is referred to for comparative purposes only and is not intended to parallel the risk or investment style of the portfolios in the MacKay Shields Composite. Internal dispersion is calculated using the equal-weighted standard deviation of annual gross returns of those portfolios that were included in the composite for the entire year. The three-year annualized standard deviation measures the variability of the composite gross returns and the index returns over the preceding 36-month period.
Convertible securities are subject to a risk of loss. Convertible securities may be subordinate to other securities. The total return for a convertible security depends, in part, upon the performance of the underlying stock into which it can be converted. Additionally, an issuer may encounter financial difficulties which could affect its ability to make interest and principal payments. If an issuer stops making interest and/or principal payments, an investor could lose its entire investment. There can be no assurance that investment objectives will be met and there is no guarantee against loss. Availability of this document and products and services provided by MacKay Shields LLC may be limited by applicable laws and regulations in certain jurisdictions and this document is provided only for persons to whom this document and the products and services of MacKay Shields LLC may otherwise lawfully be issued or made available. None of the products and services provided by MacKay Shields LLC are offered to any person in any jurisdiction where such offering would be contrary to local law or regulation. This document is provided for information purposes only. It does not constitute investment advice and should not be construed as an offer to buy securities. The contents of this document have not been reviewed by any regulatory authority in any jurisdiction. This material contains the opinions of the Convertibles team but not necessarily those of MacKay Shields LLC. The opinions expressed herein are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and opinions contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Any forward-looking statements speak only as of the date they are made, and MacKay Shields assumes no duty and does not undertake to update forward-looking statements. No part of this document may be reproduced in any form, or referred to in any other publication, without express written permission of MacKay Shields LLC. ©2022, MacKay Shields LLC. All Rights Reserved. Past performance is not indicative of future results.
COMPARISONS TO AN INDEX:
Comparisons to a financial index are provided for illustrative purposes only. Comparisons to the index are subject to limitations because portfolio holdings, volatility and other portfolio characteristics may differ materially from the index. Unlike the index, portfolios within the composite are actively managed and may also include derivatives. There is no guarantee that any of the securities in the index are contained in the portfolio. The performance of the index assumes reinvestment of dividends but does not reflect the impact of fees, applicable taxes or trading costs which, unlike the index, may reduce the returns of the portfolio. Investors cannot invest in an index. Because of these differences, the performance of the index should not be relied upon as an accurate measure of comparison.
The ICE BofA All U.S. Convertibles Index is an unmanaged index that consists of convertible bonds traded in the U.S. dollar denominated investment grade and non-investment grade convertible securities sold into the U.S. market and publicly traded in the United States. The Index constituents are market value weighted based on the convertible securities prices and outstanding shares, and the underlying index is rebalanced daily.
The NASDAQ Index is an unmanaged market-capitalization weighted index of the more than 3,000 common equities listed on Nasdaq stock exchange.
The S&P 500 Index is an unmanaged index that is widely regarded as the standard for measuring large-cap U.S. stock market performance.
The Russell 3000 Index is an unmanaged and market capitalization weighted equity index maintained by the Russell Investment Group that seeks to be a benchmark of the entire U.S. stock market. More specifically, this index encompasses the 3,000 largest U.S.-traded stocks, in which the underlying companies are all incorporated in the U.S.
The ICE BofA U.S. High Yield Index tracks the performance of U.S. dollar-denominated below investment-grade corporate debt publicly issued in the U.S. domestic market.
The ICE BofA Fixed Rate Preferred Securities Index The ICE BofA Fixed Rate Preferred Securities Index tracks the performance of fixed rate, U.S. dollar denominated, investment-grade preferred securities in the U.S. domestic market.
The Bloomberg U.S. Aggregate Index is a broad-based benchmark that measures the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM pass-through), ABS and CMBS (agency and non-agency).
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NOTE TO EUROPEAN INVESTORS
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