What can you do when the bull gets long in the tooth? Buy convertibles.
My friends at Convergex recently penned a note to Jeff Gundlach about how old this bull market really is, but that’s beside the point. The fact is that investors are eager for downside protection after a good run, but they still want upside potential. We want to have our cake and eat it, too.
The situation puts advisors like me in a fix: I don’t want to get burned trying to time the market, since this bull market has fooled the best and brightest, and I’m not claiming to be either. I just want to protect clients from the inevitable correction, but I don’t want to expensive forms of insurance for my equity holdings.
In a normal market I would just increase my bond allocation. But that’s not a great option when credit spreads are thin and Treasuries offer negative real returns.
Fortunately, I recently co-authored Alts Democratized: A Practical Guide to Alternative Mutual Funds and ETFs for Financial Advisors. Looking at over 900 Lipper alternative funds is not something I would recommend to everyone: It’s an eye-glazing experience involving a large haystack and a small needle (or two).
But the experience did train me how to spot return patterns that are not correlated with traditional asset classes. And I subsequently stumbled upon convertible bonds during a chance encounter in Boston, which I described in Convertible Bonds: The Rodney Dangerfield of Liquid Alts. (Reader beware: It’s a long article with lots of data and details.)
I began as a skeptic, thinking that convertibles are too good to be true: Full-cycle returns for convertible bonds rival the returns of stocks, but have half the volatility. And convertibles have the wonderful habit of trading like bonds during bear markets. This “asymmetric return pattern” makes convertibles an ideal holding during an aging bull market. When the bear strikes, convertibles automatically start acting more like bonds than stocks. Dynamic asset allocation is baked into the muffins.
My colleagues yawned.
I soon learned that most advisors don’t bother with convertibles for one reason or another. It’s a small asset class and it doesn’t fit into standard asset allocation models, so convertibles are usually ignored and often misclassified. The securities are “quirky, complex, and misunderstood,” in the words of James Buckham, CFA, portfolio manager at Wellesley Investment Advisors. Convertibles really are like Rodney Dangerfield—they get no respect, no respect at all.
For open-minded investors though, I offer this excerpt from an interview with James Buckham on February 20, 2015. This discussion supplements my original “Rodney Dangerfield” article, which has all the basic facts about convertibles.
Why do you like “balanced” convertibles?
You do not want deep-in-the-money bonds. You want to buy close to par, so you are protected on the downside. [This allows convertibles to act like] bonds when you want bonds, and stocks when you want stocks.”
The convertible bond fund from Wellesley has an average bond premium of about 107; the SPDR Barclays Convertible Securities ETF (CWB) has an average bond premium of about 132 (as of 2/26/15). The ETF is obviously much more equity sensitive.
As a portfolio manager, what’s interesting in the market right now?
The ETF market is relatively new, and has only experienced a bull market. We’ve given access to illiquid investments in a liquid vehicle. How will ETFs act in a bear market? This remains to be seen…
When redeeming ETF shares, will there be buyers? Markets going to the upside are fairly orderly. Market downturns are fast, and the junk bond market is vulnerable to seizing up during a bear market.
Wellesley buys 144A securities in its mutual fund. Is liquidity a concern?
Wellesley does independent credit analysis, and the firm is comfortable with the financial strength of its holdings. Moreover, 90% of 144A securities become public after a year of seasoning. [Note: As an institutional buyer, the Wellesley Convertible Bond Fund is a Qualified Institutional Buyer under SEC rules on 144A securities. But the separately managed accounts at Wellesley do not buy 144A securities.]
Why was the portfolio turnover high last year?
There were some extraordinary events that required us to exit some large positions. One company got taken over, which is a good thing. One of our holdings switched auditors and that’s a red flag that triggered a sale. We have also re-risked a little bit: We’re not terribly constructive on the equity markets.
How does duration evolve for convertible bonds?
Convertible adjusted duration is lower than what you would normally see in other corporate bonds. As the convertible bond prices go higher, they become more equity sensitive. We do a calculation based on the delta of the convertible that evolves over time. This now tends to reduce duration.
How does the new issue market look?
The new issue market is very much alive and well with over $5 billion in issuance so far in 2015. There was $4.2 billion convert deal from Allergan, and it’s good to see some big deals.
Issuance in 2013 and 2014 was $42-$44 billion, so we are now back at pre-crisis levels for issuance. [Details are in a Wall Street Journal article this week.]
The new issue environment is strong despite low interest rates. CFOs benefit from using convertibles compared to straight debt, since they get lower interest rates. And since the bonds are converted at a premium, the shareholders are happy since they’ve made money. [The stockholders benefit from lower interest expense today, in exchange for giving up a small part of the potential equity upside.]
The author has a position in MCFAX.
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