Convertible Bonds: Too Much Risk, Not Enough Reward

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Includes: AGG, CWB, PFF, SPY, TWTR, VCIT
by: Matt Hylland
Summary

In a time of rising rates, many are looking for alternatives to their bond investments.

Convertible bonds have higher yields, and have historically outperformed other bonds during periods of rising rates.

However, convertible bonds decline in tandem with stocks, and have lower returns when the market rises.

A portfolio of traditional bonds, preferred shares, and stocks has a higher yield, higher historical return, and lower volatility than convertible bonds.

Investors are always on a quest to maximize returns. Some may be attracted to long-term total returns, while others are attracted to investments that provide a certain dividend yield. However, regardless of your overall goal, there is one part of any balanced portfolio that has been struggling to produce decent returns lately - bonds.

With the low interest rates of previous years and rising rates expected in the future, many investors are stuck with low yielding bonds that appear at risk to significant declines in value if interest rates rise.

One often cited remedy for bonds in a period of rising rates is convertible bonds, or bonds that can be converted to common stock.

At first glance, they may seem attractive. The largest and most heavily traded convertible bond ETF, the SPDR Barclays Capital Convertible Bond ETF (CWB), has a yield higher than many popular bond funds used today, while also having produced superior long-term returns.

Below we compare the yields and total returns of CWB with the iShares Core Total U.S. Bond Market ETF (AGG) and the Vanguard Intermediate-Term Corporate Bond Index ETF (VCIT):

Chart CWB Dividend Yield (TTM) data by YCharts
Chart CWB Total Return Price data by YCharts

But I don't think this tells the real story. Today, investors in a convertible bond fund are taking excessive risk, and numerous alternatives exist that provide higher income and expected long-term total returns compared to convertible bonds.

What's In A Convertible Bond ETF?

First, let's take a look at the ETF we will be focusing on exclusively in this article, SPDR Barclays Capital Convertible Bond ETF.

The ETF holds both convertible bonds and convertible preferred shares, with a heavy allocation to the technology sector:

What is a typical holding of CWB like?

As an example, let's take a look at one of the fund's holdings, a convertible bond from Twitter (TWTR):

The convertible bonds pay 0.25% in interest (also described in Note 9 of Twitter's latest 10-Q), much less than if the company were to borrow traditionally in the bond market.

So why are investors lending money to Twitter at a 0.25% interest rate? Well, this is where the "conversion" part of the bond comes in.

At any time, an investor in the convertible bonds can trade their bond for 17.5 shares of Twitter's common stock per $1,000 in bond principal.

With Twitter's share price today around $37 per share, that doesn't make much sense, since 17.5 shares at today's price is only about $650, much less than the $1,000 paid for the bond.

However, imagine 4 years from now Twitter is $100 per share. Now that bond can be converted to 17.5 shares of Twitter at $100 per share, which has a total value of $1,750.

So investors in these Twitter convertible bonds are collecting a small interest payment, but really their big payout comes if Twitter's share price climbs significantly before the bond matures.

And now you may be beginning to realize that these convertible bonds are much different than your typical traditional bond. In fact, very little of this Twitter convertible bond value comes from its 0.25% interest payment, nearly all the value of the bond is based on the price and the expectation of the future price of Twitter's common stock.

And for that reason, these hardly trade like bonds at all.

CWB's Performance - Not Very Bond-Like

After our Twitter convertible bond example, it may come as no surprise to you that since CWB's inception in April of 2009, the fund has an average annual return of 11.75%, almost right in line with the S&P 500. Over that same time, an aggregate bond fund has returned just 3.6% per year and Vanguard's intermediate-term corporate bond fund VCIT has returned just under 5% per year.

Over that time, CWB has a 0.89 correlation with the US stock market, meaning that much of the fund's ups and downs simply shadow the stock market's. Said another way, these trade much more like stocks than bonds.

And while that may be desirable when the stock market is climbing, it has the potential to leave investors looking at a lot of red when the market declines.

For example, how has CWB performed during the most recent stock market correction?

Since the market highs in January, CWB has underperformed preferred shares (as measured by the iShares U.S. Preferred Stock ETF (PFF)), an aggregate bond fund (as measured by AGG), and the S&P 500 (SPY).

Chart CWB Total Return Price data by YCharts

Just over the last month, as the downtrend turned more severe, convertible bonds declined 6%, tracking much more closely to stocks than bonds.

Chart CWB Total Return Price data by YCharts

And this year's performance is not unusual. Since 2009, convertible bonds have had drawdowns that meet or exceed the general stock market during nearly every dip in the market.

Such as late 2011, when these convertibles fell 10+%, nearly perfectly following the general stock market lower from August 2011 to October 2011:

Chart CWB data by YCharts

And in mid-2015 through early 2016, where these convertible securities fell more than twice the decline in the general stock market:

Chart CWB data by YCharts

So, these "bonds" will not protect your capital like traditional bonds. But do they make up for it if the market is up?

From mid-2010 through mid-2011, convertible bonds certainly outperformed an aggregate bond fund, but returned just half of what the stock market did.

Chart CWB data by YCharts

From late 2011 through the end of 2013, after matching the decline in the stock market for the first part of the year, once again they had future returns equal to just half of the stock market.

Chart CWB data by YCharts

And lastly from early 2016, through the beginning of 2018, after declining more than twice the general stock market, they again severely lagged stocks on the way back up.

Chart CWB data by YCharts

Convertible securities have consistently fallen in near direct correlation with the stock market, but then underperform on the rebound.

So what are the arguments for these securities?

The Arguments for Convertible Bonds

A couple of years ago, Franklin Templeton Investments published a piece on convertible securities with 3 main arguments in favor for convertible bonds:

  1. Convertibles perform better than bonds in a rising interest rate environment.
  2. Convertibles have a higher income than the underlying stocks, but can appreciate more than traditional bonds.
  3. Convertibles have a low correlation to fixed income and stocks, and therefore provide extra diversification.

For the first point, they provide this graphic:

In the 5 periods of rising rates measured by Franklin Templeton, convertibles did vastly outperform 10-year Treasury bonds.

However, comparing a risky, volatile security that trades nothing like a bond with a 10-year Treasury bond is not exactly an apples-to-apples comparison.

While the three statements are correct, all three of these points neglect the idea of any kind of risk-adjusted return. Because when you consider the fact that these convertible securities have risk profiles very similar to stocks, but often much lower returns, the fact that these securities "appreciate more than bonds" becomes a pretty mute point.

An investor would be adding on a lot of risk by replacing their Treasury bonds with convertible bonds. So although their information is correct, I'm not sure it is very relevant.

Replicating CWB's Returns

Let's assume investors are worried about 3 things; total return, volatility, and yield. How do convertible bonds stack up to other alternatives available, and do investors have better options than convertible bonds in their portfolio to produce returns, reduce volatility, and/or provide yield?

Here are some more concrete numbers on the returns, volatility, and risk-adjusted returns for convertible securities and some alternate investments.

All data comes from Portfolio Visualizer.

Since January 2010:

Portfolio CAGR Std Dev Max Drawdown Sharpe Ratio Yield Today
100% CWB 8.37% 9.32% -15.56% 0.88 3.75%
100% SPY 12.78% 12.02% -16.23% 1.04 1.84%
100% AGG 2.88% 2.87% -4.07% 0.89 2.33%

As we have shown in several charts above, convertible securities have lower returns than stocks, but similar drawdowns. In other words, poor risk-adjusted returns, as shown here by the low Sharpe Ratio. Also, convertible securities are highly correlated to stocks, so splitting an allocation between stocks and convertibles (say, 60% SPY/40% CWB) makes no sense as CWB lowers the returns without doing much to reduce risk.

If you only care about total returns and don't care about volatility, replacing any allocation to CWB with SPY in your portfolio would lead to superior long-term returns.

If you are happy with the total returns that convertibles give, you can achieve it with a much lower volatility portfolio:

Portfolio CAGR Std Dev Max Drawdown Sharpe Ratio Yield Today
100% CWB 8.37% 9.32% -15.56% 0.88 3.75%

55% SPY/45% AGG

8.44% 6.48% -7.1% 1.24 2.05%

Since an aggregate bond fund has a negative correlation to stocks, the combination results in vastly reduced volatility and maximum drawdowns.

In fact, a simple split between an aggregate bond fund and the S&P 500 has achieved the same total returns as convertible bonds, but with much less volatility.

But what about if you want higher yield? After all, SPY yields under 2%, an aggregate bond fund around 2.3%, and many investors would prefer the higher dividend yield that CWB provides.

Portfolio CAGR Std Dev Max Drawdown Sharpe Ratio Yield Today
100% CWB 8.37% 9.32% -15.56% 0.88 3.75%
50% SPY/50% PFF 9.56% 8.06% -12.5% 1.14 3.79%

A portfolio of 50% preferred shares (as measured by PFF) and 50% S&P 500 has an equivalent yield as convertible bonds today, while achieving higher historical returns with lower volatility.

(The same allocation to "junk bonds" also produces higher returns and lower volatility than an allocation to CWB; however, it has a slightly lower dividend yield).

In Summary

Ultimately it is tough to justify the fund's higher risks, expenses (0.40%), and sector concentration when all the fund effectively provides is additional exposure to stocks.

However, I will admit that there are individual convertible securities available at any given time that may attractive. However, a broad based ETF of convertible securities provides little benefits for investors today.

I wrote about one of the individual securities I find attractive today in a recent article for Seeking Alpha here, titled "A 5.8% Yielding Preferred With An Escape Plan For Rising Rates"

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.