Bonds Part 6 – Convertible Bonds

Convertible bonds have been issued and traded since the 1800s; recognizing their unique value and properties, we have always included them in client portfolios. Their historical return has been close to the S&P 500 with only 65% of the risk.

Convertible bonds are hybrid securities, and they are corporate bonds with an option attached to them; that option allows conversion of the bond into the stock of the company that issues the bonds. There is no requirement to convert the bond for most convertible bonds, so it is unilateral and ultimately benefits the bondholder. A conversion ratio is associated with the option; for example, a $1,000 face value convertible bond may have a conversion ratio of 20, replacing the bond with 20 shares of the stock. In effect, the value of the bond is 20 shares of stock with a net conversion “price” of $50. If the stock price is $30/share, it will not make sense to convert since the investor would be trading a bond worth $1,000 at maturity for only $600 in stock. The value of the option becomes like an in-the-money call option when the stock price exceeds $50 per share. For example, if the price is $60 per share, then the practical value of the option is $60*20, or 1200 dollars. Now the bond begins to exhibit growth characteristics, and the value of the bond is equal to the par value of $1,000 plus the value of the option, which is $200. Suddenly your fixed-income holding is a growth holding. You can see this in the graph below, where we show the value of the bond in blue once the stock price exceeds the conversion price, the price of the stock controls the bond’s value.

So, what happens if the stock drops? Then the value is calculated in the same way in which one values a bond. They are valued based on their coupon rate, years to maturity, and credit rating. In effect, the value of the bond on its own becomes the “floor’ for the value of your investment. In this fashion, convertible bonds exhibit the best of both worlds, price stability that is more “bond” like during bear markets but the performance that is “growth” like during bull markets.

Convertibles are one of the few types of corporate bonds we will use. We do not use  High yield or “junk” bonds (without this option since they exhibit the worst characteristics, they act as stock during market declines, yet they have no potential for growth beyond their coupon payment. They also have a high average annual default rate of 6-8%, increasing dramatically during recessions. Many convertible bonds are rated at BB or below as well. Still, the option to convert to the stock provides upside potential that compensates for that, unlike “junk’ bonds that do not provide the investor with participation in the company’s success that issues the bonds.

Convertible bonds typically are issued by companies with low credit ratings but usually have high growth potential. They usually have a low coupon yield since, from an investor’s standpoint, most of the return occurs when the stock price exceeds the conversion price.

We believe strongly in the value of this asset class and estimate that it will provide 80-90% of the stock market’s return with 60-70% of its risk; that is a great combination. We invest in convertible bonds using ETFs. Convertible Bonds have been an essential part of our models since 1995 when we studied their risk vs. return characteristics and realized that they had a Sharpe ratio that dramatically exceeded the S&P 500; in the table below, we compare them to some other asset classes:

Historical Annual Rate of Return[1]Risk (Standard Deviation)Sharpe Ratio[2]
Convertible Bonds11.37%12.19%0.67
Small Cap Value13.91%19.11%0.56
International Stock10.45%16.80%0.43

As you can see, the Sharpe ratio for Convertibles is 50% higher than for the S&P 500. You may ask why would we not just replace large stocks with convertibles? In a carefully constructed portfolio to be ‘efficient”, it is crucial to have many asset classes with different characteristics. In a well-constructed portfolio, the Sharpe ratio should be well over 1.0.

The video that accompanies this blog is below. It is on our Youtube channel, “It’s Your Smarter Money – Hosted by Atlas Fiduciary” You may watch many other videos we have created there:

[1] Using all available historical information

[2] The Sharpe ratio is calculated as follows: (Return of Asset – Risk Free Rate)/Standard Deviation