Positioning for the Market’s Next Phase: Opportunity in Convertible Securities
John P. Calamos, Sr.
November 14, 2016
Senior members of the Calamos Investment Organization meet regularly to discuss the markets and investment opportunities. Below, Global Chief Investment Officer John P. Calamos, Sr. summarizes some of the team’s current thinking. He also shares his perspective on investing in a rising interest rate environment.
With the dust settling around the President-Elect Trump’s largely unexpected victory, our view is that U.S. economic growth is likely to ramp up a bit from here. The probability of an interest rate increase in December has risen, as have our inflation expectations.
While there is considerable uncertainty surrounding many elements of the President-Elect’s vision for America, there’s every reason to believe that tax reform and less regulation will be focal points. Lower corporate taxes and a reasonable level of regulation can serve as tailwinds for cap-ex spending and job growth.
Broadly, the safety trade is coming off, and our teams are seeing more opportunities in cyclical growth industries. Infrastructure and defense companies are likely to benefit from increased spending. Many financial companies are likely to benefit in an environment of higher interest rates and lower regulation.
Our portfolio managers see more crosscurrents in consumer discretionary, energy and health care. For example, consumers may benefit from increased hiring in an expanding economy, but minimum wage legislation may lose momentum. In the energy sector, there are several wildcards: the outcome of OPEC’s November 30 meeting could have a significant impact and if/how Trump revisits Keystone and the Iranian nuclear deal. Although it’s too soon to tell the ramifications to the Affordable Care Act, industry rotation is already underway and we could well see a different set of winners and losers emerge next year.
Earlier, I noted that our expectations for an interest rate increase has risen. However, the aggressive quantitative easing of other global central banks is likely to limit how far interest rates can move. It will be interesting to see how President Trump and Chair Yellen’s relationship evolves.
Broadly, our team believes that U.S. equities can benefit from Trump’s pro-growth stance, with corporate tax reform, individual tax reform and infrastructure spending providing support to the bull market. Valuations remain high in certain segments of the market, so attention to fundamentals remains essential.
Also, it has been many years since investors have had to contend with rising U.S. interest rates and inflation. I remember in the 1970s, and again in the 1980s, how investors were caught very much by surprise by rising rates. Although the backdrop is different now than it was in either of those periods, there’s every reason for investors to revisit the interest rate exposure in their asset allocations.
Actively managed convertible securities may prove very helpful. Our regular readers may recognize this table—it’s one that I’ve shared in the past. (See our Convertible Guide for an in-depth look at the asset class.) While traditional fixed income securities generally face headwinds in a rising interest rate environment, convertibles have demonstrated greater resilience, due to their equity characteristics. As the chart below shows, convertibles outperformed bonds in each period below, as well as the U.S. equity market on a variety of occasions.
Returns of Convertible Securities in Rising Interest Rate Environments
Performance data quoted represents past performance, which is no guarantee of future results. Current performance may be lower or higher than the performance quoted. Indexes are unmanaged, do not reflect fees or expenses and are not available for direct investment. The BofA ML All U.S. Convertibles Index is a measure of the U.S. convertible market. The S&P 500 Index is a measure of the U.S. stock market. The Bloomberg Barclays U.S. Govt/Credit Index is comprised of long-term government and investment grade corporate debt securities. Source: Morningstar Direct and Bloomberg. Most recent data as of 9/30/16. Rising rate environment periods from troughs to peak from October 1993 to December 2013.
Also, throughout the decades, I have long viewed convertibles as one of the most attractive hedges against equity market volatility. Although the U.S. equity market quickly recovered from its election night sell-off, it’s important to remember that volatility is a part of every market, including bull markets. Here too, convertibles can provide key benefits. As equity-linked securities, convertibles have tended to perform well when equity markets do. This is because their embedded option to convert to shares of common stock becomes more valuable.
The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Information contained herein is for informational purposes only and should not be considered investment advice. The information in this report should not be considered a recommendation to purchase or sell any particular security.
Convertible securities entail default risk and interest rate risk. Investments in high-yield securities include interest rate risk and credit risk.