At the end of July, the ICE BofA All U.S. Convertibles Index (the “Index”) had advanced more than 11% from the start of the year. Just three months later, the Index was up less than one percent. Adding to the frustration has been the relatively poor performance of the Index versus the S&P 500 and NASDAQ to which the Index is usually closely correlated. Both equity indices have benefitted from the strong performance of a handful of their largest respective constituents. The broader and more small- cap focused Russell 2000, which may be a better reflection of many companies with convertible bonds outstanding, is roughly flat for the year. Our expectation is that the performance gap between the Russell 2000 and the larger cap indices will narrow.
On a positive note, convertibles have performed far better than traditional straight bonds, highlighting their correlation to equities and historical negative correlation to interest rates. In addition, with data suggesting that inflation may have peaked, our expectation is that the advance in equities can broaden out to include more of the issuers in the convertible universe. With valuations on smaller cap companies far lower than their larger cap peers, we expect that, in the absence of a durable recession, equity advances will include a greater number of small and mid-cap companies, allowing convertibles to make up ground with the large cap equity indices.
Year-to-date, new issuance of convertible securities is well ahead of last year’s pace but still below the pace we saw in 2020 and 2021. Through the end of October, new issuance totaled just under $44 billion which is nearly twice the total for all of 2022. At the current rate, we expect this year’s new issuance to approximate $50-55 billion which is within the range of historical norms. Higher interest rates should continue to incent companies to raise capital in the convertible market as they can issue debt with a much lower coupon by providing investors the potential for upside appreciation tied to the issuer’s stock price through the bond’s conversion feature.
For investors, nearly 20% of the new convertible issuance this year has been investment grade, 1 which was incredibly scarce for the past decade as investment grade companies could sell non-convertible debt with coupons below 3%. In addition, higher rates have forced issuers to attach larger coupons to their convertible offerings. While convertible coupons remain well below those of high-yield debt, they are significantly higher than they were just one year ago. Lastly, the conversion premiums for most new issues – the amount that the common stock price needs to rise before it becomes advantageous to convert – have returned to more historical norms of 25-35% following 2021’s premiums of 50-70% for many large technology and media new issues. 1 These features – lower conversion premiums and higher coupons - should allow investors to capture a greater portion of the underlying equity’s upside move and garner an enhanced income stream versus what might have been earned in recent years past.
Fresh economic data continues to suggest that inflation has peaked. If this trend persists, it is likely that equity-linked securities such as convertible bonds may finally be able to break out of the trading range they have been stuck in for the past ten months. Equity valuations, particularly for many small and mid-cap companies, are low enough that they may even be discounting a mild to moderate recession. Barring a deeper economic contraction, we believe these securities are poised to outperform in the coming quarters.
We strive for our bottom-up process, which focuses on companies with a strong fundamental business, free cash flow and a solid balance sheet. to perform well in most market environments. In addition, by utilizing the asymmetric return profile inherent in most balanced convertible bonds, whereby an investor may participate in a greater percentage of the issuer’s equity upside than downside, we feel we are well positioned for the year ahead.