Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 115

The growing case for convertible bonds

Editor’s introductory comment: A convertible bond gives the bond holder the right to convert the bond into a defined number of shares in a company at a predetermined price. As an example from the Australian market, the long-established Listed Investment Company, Australian Financial Investment Company (ASX:AFI) issued a convertible note in February 2012 for five years, maturing 28 February 2017. It paid a 6.25% coupon, with the right to convert the bond into shares in AFI at a price of $5.09. This was about a 25% premium to the share price at time of pricing the bond. In other words, for every $100 invested, the bond holder has the right to $100/$5.09 or 19.6 shares. The current price of AFI shares is $6.16, so not only has the investor earned 6.25% on the bond, but there is an attractive conversion to AFI shares pending. Hence the bond currently trades at about $117.5 having been issued at $100.

Convertible bonds have long been under the radar relative to other asset classes. Despite the attractiveness of convertibles they are unlikely to be the first point of call for a typical investor. Yet the relative lack of attention belies the qualities of an attractive asset class that benefits from a range of characteristics that can be of value to investors.

Over the long-term, convertible bonds have demonstrated their ability to deliver equity-like returns with significantly less volatility than equities, as shown in Figure 1. Investors can benefit from upside exposure to the equity underlying a convertible whilst retaining the intrinsic downside protection of a bond. Analysis of convertible bond returns over the long-term shows attractive risk-adjusted returns and absolute returns which have approximately matched those of global equity market indices as well as corporate bonds, with volatility almost at the mid between the two.

Figure 1: Comparison global convertibles v other assets, 1996 to 2014

Income and equity characteristics

Whilst convertibles do not, by their nature, fit neatly into a fixed income or equity bucket, they can provide both fixed income and equity investors with some attractive characteristics. In discussions with investors in Australia (and globally), we have come across many different ways investors can use convertibles in their portfolios. For instance, insurance companies globally, including Australian insurers, find them attractive due to their favourable capital usage treatment relative to equities.

As Australian investors start paying more attention to the pension phase of their investment programme, they should increasingly see the appeal of the equity upside participation with downside protection offered by convertibles. Convertibles have characteristics that enable an investor to tailor a portfolio to meet their risk/reward requirements. For instance, for investors looking for an equity substitute, the portfolio can be tailored to have more upside participation (higher delta). For investors looking for a little upside for their bond portfolio, securities with more bond-like characteristics offering more downside protection (and less upside participation) can dominate the portfolio. Figure 2 shows how global convertibles can deliver less downside but with upside participation. A portfolio manager in a fund can also actively manage the average credit quality, regional allocations, industry exposures, types of convertibles and currency exposures (most convertible portfolios are fully currency hedged) to tailor the portfolio.

Figure 2. Global convertibles v MSCI annual returns, 2000 to 2014

The prospect of interest rate increases in the US is focusing attention on the tactical attractions of convertibles. In addition to their low correlation with government bonds, convertibles have shorter duration than traditional corporate credit and may therefore be more resilient during periods of rising interest rates.

The growth of the convertible universe is offering an increasing number of opportunities to investors. The global capitalisation of the convertible market is around $400 billion and is comprised of issuers across a diverse range of geographies, sectors and credit quality. The rate of convertible issuance has risen as companies increasingly identify the convertible bond market as an attractive source of capital for investment initiatives and for M&A activity. The technology and healthcare sectors in particular have been at the forefront of this trend.

Historical data shows that convertibles have demonstrated low correlation to government bonds and only moderate correlation to broader corporate credit markets, making convertibles an attractive diversification tool which can play a valuable role in portfolio optimisation.

Prospects for convertibles

The first quarter of 2015 witnessed solid year-on-year growth in global convertible issuance. We believe this trend will continue, as companies seek to secure a higher proportion of their funding from bond issuance and to reduce reliance on bank borrowing. Higher equity market valuations and the consensus expectation of rising US interest rates are also likely to have positive effects on new issuance, again providing an increased opportunity set for convertible investors.

Finally, investors can benefit from decreasing competition in the convertibles space. In recent years, bank proprietary trading desks have, by and large, closed and capital flows into convertible arbitrage hedge funds have been muted, creating valuation dispersion that may be exploited to achieve attractive returns. This is particularly topical as M&A activity has picked up in recent months. Many convertible bonds have attractive structural features that allow significant upside participation in the event of takeover.

Although not indicative of future performance, historical performance suggests that a strategic allocation to convertibles can reasonably be expected to increase a portfolio’s expected return for a given level of risk, given their low correlation to other fixed income assets, making the convertible market an attractive tool for investors. In addition, the present macro environment, with the potential for increased interest rates, possibly higher equity market volatility and increased M&A activity, should prove supportive for returns from the convertible bond market, proving it an asset class worthy of more attention from investors.

 

James Peattie is Senior Portfolio Manager at CQS Investment Management Limited, a London-based manager of alternative assets.

Editor’s note: Convertible notes issued on the ASX are listed in the Interest Rates Securities section at the back of The Australian Financial Review and the ASX has more information here. Many bond funds also make an allocation to convertibles bonds. Neither Cuffelinks nor CQS is recommending any of these investments and readers should take financial advice before making investment decisions.

 

2 Comments
Graham Hand
June 29, 2015

Hi Sean, I'll reply since your comment relates to the Editor's Note. It is the case that the Australian domestic convertible market is dominated by instruments that give a fixed income coupon but little or no equity upside and in extreme cases,equity downside. However, most large global convertibles are different from the Australian domestic deals the commentator refers to and do provide investors with downside protection combined with proper equity upside participation, with conversion prices fixed pre-issue.

Sean I
June 28, 2015

The conversion price and terms aren't all as rosy as AFI. Many notes do not have conversion prices based on pre-issue prices, but rather pre conversion prices. This is a significant difference for the investor. AFI convertible notes are a great example of where an investor can get a fixed income while still participating in equity upside as any growth from the pre-issue price would result in a favourable outcome at conversion. The issue is that for many other convertibles, you are getting the fixed income, but not really participating in the equity upside.

As a result you often aren't getting the desired outcome, and in fact face higher risks, a lower rung on the ladder of who gets paid, and unfavourable terms with regards to when payments can be withheld, when notes can or must be converted to shares, and relatively poor liquidity in the event of a significant market event.

These are fantastic investments for investors to get an understanding of, but if they don't understand what they're giving up, what they're gaining and how it is going to look at maturity, they shouldn't be investing in them.

The terms for investors for issues of hybrids and convertibles have gotten steadily worse since the GFC, as the appetite from individual and SMSF investors that don't understand the risks has risen to offset institutional demand that find the terms and compensation relatively unattractive. Buyer beware.

 

Leave a Comment:

RELATED ARTICLES

Read this before you go all in on US equities

Is FOMO overruling investment basics?

Feel the fear and buy anyway

banner

Most viewed in recent weeks

Maybe it’s time to consider taxing the family home

Australia could unlock smarter investment and greater equity by reforming housing tax concessions. Rethinking exemptions on the family home could benefit most Australians, especially renters and owners of modest homes.

Supercharging the ‘4% rule’ to ensure a richer retirement

The creator of the 4% rule for retirement withdrawals, Bill Bengen, has written a new book outlining fresh strategies to outlive your money, including holding fewer stocks in early retirement before increasing allocations.

Simple maths says the AI investment boom ends badly

This AI cycle feels less like a revolution and more like a rerun. Just like fibre in 2000, shale in 2014, and cannabis in 2019, the technology or product is real but the capital cycle will be brutal. Investors beware.

Why we should follow Canada and cut migration

An explosion in low-skilled migration to Australia has depressed wages, killed productivity, and cut rental vacancy rates to near decades-lows. It’s time both sides of politics addressed the issue.

Are franking credits worth pursuing?

Are franking credits factored into share prices? The data suggests they're probably not, and there are certain types of stocks that offer higher franking credits as well as the prospect for higher returns.

Are LICs licked?

LICs are continuing to struggle with large discounts and frustrated investors are wondering whether it’s worth holding onto them. This explains why the next 6-12 months will be make or break for many LICs.

Latest Updates

A nation of landlords and fund managers

Super and housing dwarf every other asset class in Australia, and they’ve both become too big to fail. Can they continue to grow at current rates, and if so, what are the implications for the economy, work and markets?

Economy

The hidden property empire of Australia’s politicians

With rising home prices and falling affordability, political leaders preach reform. But asset disclosures show many are heavily invested in property - raising doubts about whose interests housing policy really protects.

Retirement

Retiring debt-free may not be the best strategy

Retiring with debt may have advantages. Maintaining a mortgage on the family home can provide a line of credit in retirement for flexibility, extra income, and a DIY reverse mortgage strategy.

Shares

Why the ASX is losing Its best companies

The ASX is shrinking not by accident, but by design. A governance model that rewards detachment over ownership is driving capital into private hands and weakening public markets.

Investment strategies

3 reasons the party in big tech stocks may be over

The AI boom has sparked investor euphoria, but under the surface, US big tech is showing cracks - slowing growth, surging capex, and fading dominance signal it's time to question conventional tech optimism.

Investment strategies

Resilience is the new alpha

Trade is now a strategic weapon, reshaping the investment landscape. In this environment, resilient companies - those capable of absorbing shocks and defending margins - are best positioned to outperform.

Shares

The DNA of long-term compounding machines

The next generation of wealth creation is likely to emerge from founder influenced firms that combine scalable models with long-term alignment. Four signs can alert investors to these companies before the crowds.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.