Investing in hybrid bonds increases income and reduces some risks.
Summer fun can include long drives along the coast on a two-seater cruise with the top down. While the summer season has come and gone and it may be time to park the sports car and replace the top as colder seasons and inclement weather approach, consider this – convertibles can also be used for invest and they can offer more than just driving fun. Convertible bonds, a hybrid investment, are always in vogue as part of any diversified all-weather investment portfolio.
Hybrids are all the rage among car buyers. And convertibles are a perennial favorite of car enthusiasts. Both can also be part of a long-term investment portfolio.
Convertible bonds may be unfamiliar to most investors, but they are a great tool to help minimize risk in any investment portfolio. Convertible bonds are hybrid investment vehicles that offer the best of both worlds: income now as a bond and the potential to capture appreciation later as a share.
Get paid while you wait
Convertibles offer investors a fixed return like any other bond. This regular income offers better downside protection than simply holding stocks. They also have a feature that allows the bondholder to exchange the bond for a certain number of shares on a predetermined date. This feature makes these hybrid bonds advantageous in inflationary times when stock prices may be rising and other bonds are falling in value. During market corrections or bear markets, investors receive interest while they wait for the next recovery or bull market.
Like any other bond, there is an underlying credit risk to the issuer. The conversion opportunity also means that the convertible bond can track the underlying stocks more closely and have higher volatility than plain bonds. However, the hybrid nature of this investment provides corresponding benefits to help offset this risk.
Convertible bonds as a separate asset class evolve
As an asset class, convertibles have been around for more than 150 years. From December 1973 to mid-2010, the convertible bond index has had total returns (interest plus appreciation) of 2736%, outperforming the government / corporate bond index by 943% and finishing above the high yield bond index. (aka junk) of 1585% (BofA / Merrill Lynch Convertible Research, 6/30/10).
Convertible Bonds have evolved with the times. In the past, many were issued by smaller companies that had no other means of accessing capital. Over the past 15 years, Convertible Bonds have become more prevalent among the largest brand-name firms, and corporate treasurers have added them to their mix of ways of financing companies without immediately diluting shareholders. They remain a reference strategy for growing companies in the technology, pharmaceutical and bioscience sectors.
In the past, convertible bonds were more prone to large changes in value because the window that offered the conversion option was generally very distant. Many now offer windows for converting into stocks that are relatively short – 3-5 years, reducing the holding period the bond investor needs to collect and get their money back with interest or a gain on stocks.
Advantages of convertible bonds
During the tightening of the Fed, convertibles have performed well. Interest rates inevitably rise from their historically low rates with or without inflation. While the value of other high-quality corporate and government bonds will suffer when interest rates rise, convertible bonds will likely hold their value, continue to pay interest, and offer the potential for higher returns when converted to stocks. (For a whitepaper detailing this, visit http://www.ClearViewWealthAdvisors.com and post a request.)
1. Higher performance than most stocks (currently> 3.5%)
2. Potential to capture appreciation
3. Greater diversification and lower potential risk as a result of the low correlation with stocks and bonds
4. History of capital preservation
5. Unlike other bonds, convertible bonds have generally performed well during periods of the Fed’s tightening of interest rates or inflationary periods.
