Why Convertibles Should be on Your Radar in a Rising Rate Environment

Why Convertibles Should be on Your Radar in a Rising Rate Environment

As evidenced by the significant bond sell-off earlier this year, a growing body of investors appears to believe that we are facing a period of rising interest rates.

The timing is uncertain, as the US Federal Reserve recently deferred its plans to start “tapering” its $85 billion-per-month bond purchasing program, which, along with a declining unemployment rate, would pave the way for future interest rate hikes. But, investors are looking for ways to be ready in advance, so their portfolios are not caught unprepared.

Whenever interest rates do rise, the good news is that this is often a sign that the health of the US economy is improving. The not-so-good news if you’re a bondholder or yield-seeker is that bonds typically lose value during rising rate environments, while equity prices have often increased.

To be sure, stocks historically have tended to struggle at the onset of inflation. However, once inflation has made its way into the system, stocks have performed better during the latter part of an inflationary period — especially when the inflation is triggered by economic growth. For example, from 1966 to 1981, stocks, with an average return of 5.95%, did not outperform inflation, according to S&P 500 data. In the last seven years of this inflationary period, which lasted from 1975 to1981, stocks returned more than 14%.

Despite the negative impact of rising rates, investors can take solace in knowing that not all bonds are created equal, and there’s a sector of the bond market that may stand to weather rising rates: convertible bonds.

Convertible bonds, which have hybrid characteristics of both stocks and bonds, historically have taken on equity-like qualities during rising rate environments because the holder has the option to convert the bonds into a predetermined number of issuer shares. At the same time, they’ve provided a measure of downside protection due to their bond component. As a result, adding convertibles to your portfolio may increase your participation in the stock market movement and lower your portfolio’s interest rate sensitivity.

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Source: Bloomberg L.P.

What’s more, convertibles have tended to have a shorter duration of time it takes the bonds to mature, making them less sensitive to rising interest rates. The average convertible market has historically been about three to 3.5 years1, compared to four to 5.5 years, respectively, for the corporate high-yield and aggregate bond markets.2

We believe convertibles are a dynamic asset class that can help you pursue your asset allocation goals in many different ways. If you’re looking to add an interest rate hedge to your portfolio, we believe over the long-term, convertibles may be an option to consider.

1 Source: Bank of America. As measured by the Bank of America Merrill Lynch All US Convertibles Index.

2 Source: Barclays. As measured by the Barclays U.S. Corporate High Yield Bond Index and Barclays U.S. Aggregate Bond Index, respectively.

Important information

Basis point (bps) is the smallest measure used for quoting yields on bonds and notes. One basis point is one one-hundredth of a percentage point, or 0.01%.

The BofA Merrill Lynch All U.S. Convertibles Index is an unmanaged index that measures performance of US dollar-denominated convertible securities not currently in bankruptcy with a total market value greater than $50 million at issuance.

The S&P 500® Index is generally representative of the US stock market.

The Barclays U.S. Government Credit Index includes Treasuries and agencies that represent the government portion of the index, and it includes publicly issued US corporate and foreign debentures and secured notes that meet specified maturity, liquidity and quality requirements to represent the credit interests.

The Barclays U.S. Corporate High Yield Bond Index is an unmanaged index that covers the universe of fixed-rate, noninvestment-grade debt.

The Barclays U.S. Aggregate Bond Index is an unmanaged index considered representative of the U.S. investment-grade, fixed-rate bond market.

Past performance cannot guarantee future results. An investment cannot be made directly in an index.

Investments in convertible securities are subject to the risks associated with both fixed-income securities, including credit risk and interest rate risk, and common stocks. Convertible securities may have lower yields because they offer the opportunity to be converted into stock and if the stock is underperforming and the bond does not convert then the bond may have a lower return than a non-convertible bond.

Convertible securities may be affected by market interest rates, issuer default, the value of the underlying stock or the right of the issuer to buy back the convertible securities.

Fixed-income investments are subject to credit risk of the issuer and the effects of changing interest rates. Bond prices generally fall as interest rates rise and vice versa.

In general, stock and other equity securities values fluctuate in response to activities specific to the company as well as general market, economic and political conditions.

Thomas Bastian, CFA

Senior Portfolio Manager

Senior Portfolio Manager Thomas Bastian is the lead manager for Invesco large-cap relative value strategies.

He joined Invesco in 2010. Prior to joining the firm, he was a portfolio manager for the US value products at Van Kampen, which he joined in 2003. Before Van Kampen, he was a portfolio manager at Eagle Asset Management and an analyst at Bank One. He entered the industry in 1997.

Mr. Bastian earned a BA degree in accounting from St. John’s University and an MBA from the University of Michigan. He is a CFA charterholder and a member of the CFA Institute and the Houston Society of Financial Analysts.

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