Investing

A market ripe for convertibles

With stock market volatility on the rise, the time is right for financial advisers to consider convertibles for a place in client portfolios.

Convertible securities are either bonds or shares of preferred stock that can be exchanged for shares of a company’s common stock. As such, they tend to benefit from both the potential price appreciation of the underlying common stock and the income of the convertible security.

Here are four reasons for advisers to take a fresh look at this little-understood and under-appreciated asset class.

• Greater market volatility. As measured by the Chicago Board Options Exchange’s Volatility Index, market volatility has risen sharply since the summer of 2007, reaching levels not seen since 2003. While increased periods of volatility are a normal part of the ebb and flow of market cycles, prolonged instability can cause clients to become nervous and too focused on the short term. That might lead them to make bad decisions, or even to act against your advice.

Adding convertibles to a client’s portfolio can dampen volatility while preserving much of the portfolio’s upside potential.

Studies have shown that convertible securities have produced near-equity returns over the long-term with significantly less risk. According to an analysis by Putnam Investments of Boston covering the 10 years through December 2007, convertibles produced an average annual return of 7.09% — as measured by the Merrill Lynch All Convertible Securities Index – outpacing the 5.91% return for the Standard & Poor’s 500 stock index.

Yet the average standard deviation of the convertible securities index, a measure of risk, was 12.6%, compared with 14.7% for the S&P 500. One reason for this performance advantage in recent years is that in falling stock markets, such as those in 2000-03, the debt portion of the convertible security typically cushions the effects of a market decline.

• Stronger performance drivers. The two most important factors influencing the performance of convertibles are the direction of the broad equity market and credit spreads, or the difference in yield between Treasuries and lower-quality bonds. Due to the crisis in the mortgage market and contagion effects in peripheral fixed-income markets, credit spreads have widened since July 2007 to well above historic levels.

We think that wider credit spreads, combined with greater equity market volatility, have moved the convertibles market from being slightly overvalued to being slightly undervalued.

These factors, along with continued healthy levels of new issuance activity at attractive prices, have provided the market with a significantly expanded set of investment opportunities.

• Good fit with current market leadership. If growth stocks continue to outperform value stocks, convertible securities may represent a better alternative to many of the traditional approaches advisers take to reduce portfolio volatility. These traditional approaches include increasing the use of utility stocks or income-oriented equity funds, both of which are heavily populated with value-oriented names.

Convertibles, by contrast, are frequently issued by rapidly growing companies, and therefore the asset class as a whole tends to skew in the direction of growth and core equities, rather than value stocks.

• Portfolio diversification. Convertible securities traditionally have had a low correlation to stocks and fixed-income securities. In fact, during the 10 years through December 2007, convertibles were negatively correlated with the Lehman Aggregate Bond Index (-0.11), exhibited a low correlation (0.61) with high-yield bonds, and had a similarly low correlation (0.8) with the S&P 500. This low correlation means that adding convertibles to a traditional portfolio of stocks and bonds may improve the portfolio’s overall risk-adjusted return potential.

David King is a senior equity portfolio manager and Robert Salvin is a fixed income portfolio manager with Putnam Investments of Boston.

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