Investing in hybrid bonds increases income and reduces some risks.
Summer fun can include long trips along the coast in an open-top two-seater cruiser. While the summer season has come and gone and it may be time to park the sports car and put the top back up as the cooler seasons and inclement weather approach, consider this: Convertibles can also be used for invest and can offer more than just fun behind the wheel. Convertible bonds, a hybrid investment, are always in style 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 stock.
Earn money while you wait
Convertibles offer investors a fixed return like any other bond. This regular income offers better protection against loss than simply holding the stock. They also have a feature that allows the bondholder to trade the bond for a certain number of shares on a predetermined date. This feature makes these Hybrid Bonds advantageous during inflationary times when stock prices may be rising and other bonds lose 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 of the issuer. The conversion opportunity also means that the convertible bond can track the underlying stock more closely and have higher volatility than straight bonds. However, the hybrid nature of this investment provides corresponding benefits to help offset this risk.
Convertible bonds as a stand-alone asset class evolve
As an asset class, convertibles have been around for more than 150 years. From December 1973 through mid-2010, the Convertible Bond Index had total returns (interest plus appreciation) of 2,736%, outperforming the Government/Corporate Bond Index by 943% and finishing above the High Yield Bond Index. (also known as scrap) 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. In the past 15 years, convertible bonds have become more prevalent among the biggest brand name firms, and corporate treasurers have added them to their mix of ways to finance companies without immediately diluting shareholders. They continue to be a go-to strategy for growing companies in the technology, pharmaceuticals and life sciences sectors.
In the past, convertible bonds were more prone to large changes in value because the window providing the conversion option was generally so far away. Many now offer windows to convert to stocks that are relatively short—3 to 5 years—reducing the holding period needed for a bond investor to cash in and get their money back with interest or a stock gain.
Advantages of convertible bonds
During the Fed’s tightening, convertibles performed well. It is inevitable that interest rates will rise from their historically low rates with or without inflation. While the value of other high-quality government and corporate bonds will suffer when interest rates rise, convertible bonds will likely hold their value, continue to pay interest, and offer the potential for higher yields when converted to shares. (For a white paper detailing this, visit http://www.ClearViewWealthAdvisors.com and post a request.)
1. Outperforms most stocks (currently > 3.5%)
2. Potential to capture appreciation
3. Greater diversification and lower potential risk resulting from the low correlation with stocks and bonds
4. Capital preservation track record
5. Unlike other bonds, convertible bonds have generally performed well during periods of Fed tightening to raise interest rates or periods of inflation.
