Convertible bonds-

This short piece is designed to offer some insight into convertible bonds as a stand alone placement in a portfolio. Typically they are a small portion of a high yield bond fund.

Convertible bond portfolios are designed to offer some of the capital-appreciation potential of stock portfolios while also supplying some of the safety and yield of bond portfolios. To do so, they focus on convertible bonds and convertible preferred stocks. Convertible bonds allow investors to convert the bonds into shares of stock, usually at a preset price. These securities thus act a bit like stocks and a bit like bonds.

They possess five potential systemic risk factors. A manager who can identify, manage and exploit these has the potential for a placement in a portfolio.

  • Interest rate risk-it is a bond
  • stock market risk-it can be converted to equity
  • credit risk-it is a bond
  • volatility risk
  • illiquid

Successful managers are able to hedge the unwanted risks and keep the ones with solid return potential.

We took two funds for a basic comparison on risk and return. The Vanguard Convertible Securities Fund and the Vanguard S&P500 Fund.

Vanguard Convertible Securities Fund VCVSX Vanguard S&P 500 FUND VFINX
Standard Deviation 11.79 15.25
Sharpe .9 .93
Beta 1.16 1
Alpha -.85 -.14
2008 decline -29.79% -37%
turnover 82% 4%
expense .59% .17%

On this comparison alone, it appears that there is little reason to invest in a stand alone convertible bond fund.  There are other fund managers that have alpha generating skills so there may be the possibility of a placement but keep in mind the inherent volatility of this asset class.

According to Calamos, a reasonably well known convertible bond house, the convertible market, as measured by the BofA Merrill Lynch All U.S. Convertibles Index (VXA0), posted a solid 2.80% return in the fourth quarter and outperformed the slight decline of 0.38% in the S&P 500 Index. Fourth quarter returns in the convertible market were supported by the strong performance of the convertibles’ underlying equities and declining credit spreads, which provided support to the bond component of the convertibles.

If declining credit spreads were a main determinant for strong performance, it may make sense to hold off on a placement as spreads may not have much room to tighten and if we hit a rough patch in the economy, may widen. Also, equity volatility as displayed by the VIX index is very low as well. So with the potential for a rise in interest rates, credit spread widening and an increase in volatility, we recommend a cautious stance with this specific asset class.