The rationale for convertible bonds late in equity-market cycles
Although convertibles have tended to outperform equities over longer time frames, the rationale for investing in them is especially compelling during the latter stages of market cycles.
Whereas convertibles suffered a decline equivalent to 62 per cent of the fall incurred by equity markets during the financial crisis, they enjoyed 80 per cent of the return generated by equities in the following five years. A similar pattern was seen during the market downturn of 2000-02, when convertibles fell 52 per cent as far as equities but then recovered 65 per cent as far.
This means for investors who fear equities are entering the latter stages of the cycle, a portfolio of balanced convertible bonds can provide a means to maintain exposure to equity markets while mitigating the risk of market declines.
Such asymmetry of the return profile of convertible bonds is explained by the fact that, while the call option embedded within them offers exposure to equities in rising markets, they also have bond-like characteristics. Essentially this means prices have the potential outperform underlying equities when stock markets are falling. And the fact that most convertibles have a relatively low duration means interest rate risk tends not to be a big driver of returns.
The value of an investment and any income from it can go down as well as up and can fluctuate in response to changes in currency exchange rates. Investors may not get back the original amount invested.
Convertible securities risk
Convertible bonds can earn less income than comparable debt securities and less growth than comparable equity securities, and carry a high level of risk.
Bond values are affected by changes in interest rates and the bond issuer's creditworthiness. Bonds that offer the potential for a higher income typically have a greater risk of default.
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