A market ripe for convertibles

With stock market volatility on the rise, the time is right for financial advisers to consider convertibles for a place in client portfolios.
MAR 24, 2008
By  Bloomberg
With stock market volatility on the rise, the time is right for financial advisers to consider convertibles for a place in client portfolios. Convertible securities are either bonds or shares of preferred stock that can be exchanged for shares of a company's common stock. As such, they tend to benefit from both the potential price appreciation of the underlying common stock and the income of the convertible security. Here are four reasons for advisers to take a fresh look at this little-understood and under-appreciated asset class. • Greater market volatility. As measured by the Chicago Board Options Exchange's Volatility Index, market volatility has risen sharply since the summer of 2007, reaching levels not seen since 2003. While increased periods of volatility are a normal part of the ebb and flow of market cycles, prolonged instability can cause clients to become nervous and too focused on the short term. That might lead them to make bad decisions, or even to act against your advice. Adding convertibles to a client's portfolio can dampen volatility while preserving much of the portfolio's upside potential. Studies have shown that convertible securities have produced near-equity returns over the long-term with significantly less risk. According to an analysis by Putnam Investments of Boston covering the 10 years through December 2007, convertibles produced an average annual return of 7.09% — as measured by the Merrill Lynch All Convertible Securities Index - outpacing the 5.91% return for the Standard & Poor's 500 stock index. Yet the average standard deviation of the convertible securities index, a measure of risk, was 12.6%, compared with 14.7% for the S&P 500. One reason for this performance advantage in recent years is that in falling stock markets, such as those in 2000-03, the debt portion of the convertible security typically cushions the effects of a market decline. • Stronger performance drivers. The two most important factors influencing the performance of convertibles are the direction of the broad equity market and credit spreads, or the difference in yield between Treasuries and lower-quality bonds. Due to the crisis in the mortgage market and contagion effects in peripheral fixed-income markets, credit spreads have widened since July 2007 to well above historic levels. We think that wider credit spreads, combined with greater equity market volatility, have moved the convertibles market from being slightly overvalued to being slightly undervalued. These factors, along with continued healthy levels of new issuance activity at attractive prices, have provided the market with a significantly expanded set of investment opportunities. • Good fit with current market leadership. If growth stocks continue to outperform value stocks, convertible securities may represent a better alternative to many of the traditional approaches advisers take to reduce portfolio volatility. These traditional approaches include increasing the use of utility stocks or income-oriented equity funds, both of which are heavily populated with value-oriented names. Convertibles, by contrast, are frequently issued by rapidly growing companies, and therefore the asset class as a whole tends to skew in the direction of growth and core equities, rather than value stocks. • Portfolio diversification. Convertible securities traditionally have had a low correlation to stocks and fixed-income securities. In fact, during the 10 years through December 2007, convertibles were negatively correlated with the Lehman Aggregate Bond Index (-0.11), exhibited a low correlation (0.61) with high-yield bonds, and had a similarly low correlation (0.8) with the S&P 500. This low correlation means that adding convertibles to a traditional portfolio of stocks and bonds may improve the portfolio's overall risk-adjusted return potential. David King is a senior equity portfolio manager and Robert Salvin is a fixed income portfolio manager with Putnam Investments of Boston. For archived columns, go to investmentnews.com/investmentstrategies.

Latest News

IRA rollovers from DC plans to hit $1.15T by 2030, LIMRA says
IRA rollovers from DC plans to hit $1.15T by 2030, LIMRA says

Research highlights the dominant role of workplace retirement plans and breaks down the major factors dictating workers' IRA rollover decisions.

GReminders unveils autonomous AI assistant for financial advisors
GReminders unveils autonomous AI assistant for financial advisors

The wealth tech firm is rolling out its "Do Anything" assistant as leaders and strategists tout the next evolution of artificial intelligence.

Court strikes down SEC CAT funding plan, puts broker-dealer costs under fire
Court strikes down SEC CAT funding plan, puts broker-dealer costs under fire

Appeals court overturns SEC’s CAT funding plan, broker-dealers face new uncertainty.

FINRA fines second broker-dealer over misleading communication with clients about crypto
FINRA fines second broker-dealer over misleading communication with clients about crypto

TradeStation Securities' communications violated industry rules, including falling short on describing the risks involved in investing in volatile crypto assets.

Advisor moves: Osaic welcomes Valic veteran in Arizona, Janney hails $3.3B recruiting haul
Advisor moves: Osaic welcomes Valic veteran in Arizona, Janney hails $3.3B recruiting haul

Meanwhile, a father-son pair of advisors and ex-marines from ex-Edward Jones gives Kingsview its newest location in Arkansas.

SPONSORED How advisors can build for high-net-worth complexity

Orion's Tom Wilson on delivering coordinated, high-touch service in a world where returns alone no longer set you apart.

SPONSORED RILAs bring stability, growth during volatile markets

Barely a decade old, registered index-linked annuities have quickly surged in popularity, thanks to their unique blend of protection and growth potential—an appealing option for investors looking to chart a steadier course through today's choppy market waters, says Myles Lambert, Brighthouse Financial.