Given our expectation of elevated equity market volatility and the likelihood of rising interest rates, we believe that the hybrid equity/fixed income characteristics of convertibles can prove particularly advantageous.
While the global convertible benchmark has demonstrated greater resilience than the global equity market during the recent market turbulence, the U.S. convertible market experienced unusual but not entirely unprecedented performance trends. The U.S. convertible market, as measured by the VXA0, declined further than the S&P 500 Index (Figure 11). In large measure, this was due to the larger representation of smaller-cap and more growth-oriented names within the index.
FIGURE 11. CONVERTIBLE MARKET PERFORMANCE
Past performance is no guarantee of future results. Source: BofA Merrill Lynch, Bloomberg, MSCI.
Importantly, our research has shown that when convertibles trail the S&P 500 during a down quarter, they have posted positive performance two-thirds of the time during the following quarter. In part, this is because investors tend to recognize the fixed-income attributes of the convertible, such as the bond value. This isolated quarter should not challenge the use convertibles as a way to secure equity market participation with reduced downside volatility. However, the volatility contributing to the performance over the third quarter does underscore that active management is essential to capitalize on the benefits that convertibles can offer through full and multiple market cycles.
Our recent positioning has been cautious but not defensive, consistent with our view that the pace of global economic acceleration is likely to slow, but not cease. In this low growth environment, companies with strong balance sheets that generate above-average organic growth have typically been rewarded by investors, which is where our team has increased its focus.
We have continued to identify many opportunities within the consumer discretionary sector, framed by a positive wealth effect, that has been supported by encouraging dynamics in the housing market and attractive mortgage rates, employment gains, solid consumer confidence and strong auto sales. Our emphasis on secular growth companies has led us to health care and technology. In regard to health care, we are focused on Medicaid expansion, changes in utilization, home health trends, personalized medicine and genome sequencing. In contrast, we’ve been underweight to heavy cyclicals including energy, materials, and industrials for most of this year.
However, the type of convertible structures we chose to invest in are just as important as the overall sector allocations. Our current positioning is reflective of our cautious optimism as we seek balanced risk/reward convertibles that still participate on the upside and protect on the downside in what we believe will continue to be a volatile environment.
Although issuance has fallen from levels a year ago, the global convertible market continues to provide us with sufficient breadth. Year-to-date issuance totals $63 billion (USD) versus $73 billion at the end of 3Q 2014. Issuance during the vacation months of July and August are typically light, and this year was no exception. September is usually a strong month but was likely lighter this year due to considerable equity market volatility, as material declines in stock prices tend to prompt corporations to delay issuance. Expectations suggest a decent uptick in issuance over the fourth quarter.