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As Convertible Bond Issuance Soars, Investors Should Be Cautious

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07/09/2018 | 02:19 am


By Jeff Brown



U.S. issuance of convertible bonds has soared this year along with a rise in interest rates, as companies look for cheaper ways to raise capital and income-oriented investors hunt for assets that can outperform humdrum holdings like Treasurys without a wild ride.



Some experts, however, say investors may be underestimating how tricky these securities can be to evaluate and how much risk is actually associated with them.



A cross between debt and equity, convertibles typically pay a lower yield than an ordinary corporate bond because investors can swap them for equity under terms set when the bonds are issued. Some experts say investors who need to keep their nest eggs intact for a long retirement may find them particularly appealing, drawn to their promise of steady income, as well as capital gains if stocks prosper.



The ideal convert investor wants a better return on fixed-income investments, has a three- to five-year investment horizon and is bullish on stocks, but also wants the loss protection provided by the return of principal if the investor doesn't convert to stock, says Arnaud Brillois, portfolio manager on the global convertibles team at Lazard Asset Management.



Companies have sold $46.1 billion of convertibles this year through April, versus $35.5 billion for all of 2017, according to UBS Group, the Swiss investment bank. At the current pace, issuance of convertibles will beat the $102.3 billion U.S. record of 2007.



"Issuance is up because interest rates are higher and rising," says Dave King, portfolio manager of Columbia Threadneedle's Columbia Convertible Securities Fund (PACIX). "Some companies that would have issued regular bonds two years ago are now being priced out of the straight bond market and into the convertible market."



Proceed with caution?



Advocates say investors may find convertibles especially attractive now because of their low default rates and the good results they've produced when interest rates rise.



SPDR Bloomberg Barclays Convertible Securities (CWB), an exchange-traded fund that tracks the convertible-debt market, yields just under 4% and has average annual returns of 10.2% for the five years through June, says Morningstar. By comparison Vanguard Long-Term Corporate Bond Index Fund (VCLT), one of many ETFs tracking ordinary corporate bonds, yields a slightly richer 4.43%, but has returned just 6.21% a year for the past five years, well under the CWB return.



That makes convertibles look good, but some financial pros say these securities can be tricky for investors accustomed to ordinary stocks, bonds and funds. Each convertible bond is essentially a customized contract, and terms can vary. Investors can face interest-rate risk, default risk, stock-market risk and call risk -- when principal is returned early, likely at a bad time to reinvest.



"This is the perfect climate for companies to issue convertible bonds and likely the worst time for investors to buy them," says Robert R. Johnson, principal at the Fed Policy Investment Research Group and former president of the American College of Financial Services. He worries that convertible prices, like those of most bonds, will be damaged by rising interest rates.



The Federal Reserve has raised short-term rates twice this year, and the markets expect two more increases. That threatens many fixed-income investments, as investors favor new issues that pay more.



But convertibles often flourish in these conditions, says a study issued in March by Gabelli Funds. It found that in each of the past eight periods in which the 10-year U.S. Treasury note's yield rose at least 1 percentage point, convertibles outpaced Treasurys. They beat junk bonds in four of the eight periods and even outpaced the S&P 500 in two.



"Rising interest rates frequently occur in strong economic times, when growing earnings can lead to higher stock prices," says Mr. King, whose fund has returned 9.3% annually over the past five years. "This is not to say that convertible managers root for higher interest rates, but the relatively strong performance of the asset class in past rising rate environments is a documented fact."



Not a bond substitute



Nicole Tanenbaum, chief investment strategist at Chequers Financial Management in San Francisco, says converts behave like bonds when they are new but more like stocks as they age. She and others say converts shouldn't be viewed as an alternative to ordinary bonds like Treasurys. "An investor looking for bonds to act as the steady ballast of a portfolio should not use converts for this purpose, since they carry more equity-like volatility along with credit risk," Ms. Tanenbaum says.



While converts aren't as safe as Treasurys, the gold standard in safety, they are nowhere near as risky as high-yield, or junk, bonds. Default rates average about 1%, versus 4% for junk bonds, according to Barclays Equity Research.



Still, investors shouldn't shrug off the risk of default, says John Hagensen, managing director of Keystone Wealth Partners in Scottsdale, Ariz. "Many companies issuing convertible bonds are low quality, so the default risk during bear markets is extremely high," Mr. Hagensen says.



Also, a falling share price can make the conversion feature worthless, leaving just the interest earnings, and driving down the bond price for the investor who must sell before getting principal back at maturity.



Shopping for a convert, therefore, takes evaluation that could be tricky for some individual investors, requiring study of both the bond and stock prospects. Among the devils in the details: What is the conversion stock price? Can the company "call" or repay principal early? Can it force a conversion under certain conditions?



Investors can leave the research work to professionals with a managed account. There also are a number of actively managed and passive funds focused on convertibles.



"Convertible bonds have complex legal clauses that can be triggered for a variety of reasons, which necessitates constant monitoring," Lazard's Mr. Brillois says. "For these reasons, I believe it is best for investors to rely on specialist convertible-bond managers, and to invest through funds."



Mr. Brown is a writer in Livingston, Mont. He can be reached at reports@wsj.com.





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