Increased corporate earnings, improvements in a wide variety of economic data, and the anticipation of a set of pro-growth policy measures in the coming months all suggest good times ahead for convertible securities.
Convertible market issuance is about capital market access; capital market access is closely tied with economic growth. As better economic prospects spur increased interest in risk assets, we’d expect a continued upswing in convertible issuance.
The convertible market has a heavy representation of issuers with smaller market caps, larger domestic focus, lower dividend yields, and higher tax rates and contains fewer “safety trade” names. We like convertibles as an asset class in this environment, given their historical outperformance over straight bonds when both interest rates and equities are projected to climb.
For financial advisors looking for a resource (or refresher) on how convertibles work, we’ve just re-released our updated 32-page Convertible Securities: Structures, Valuation, Market Environment and Asset Allocation guide.
Convertible securities have the ability to participate in any continued market upside while also providing a measure of downside protection in the event of an equities pullback.
The guide is written by Calamos Founder, Chairman and Global Chief Investment Officer John P. Calamos, Sr., with contributions from Eli Pars, CFA, Calamos Co-CIO, Head of Alternative Strategies and Co-Head of Convertible Strategies and Senior Co-Portfolio Manager.
Calamos’ origins are as an institutional convertible bond manager. John Calamos is often quoted as an authority on risk-managed investment strategies, markets and the economy, and has authored two books on convertible securities.
What follows are five insights from the guide. Download the full guide for more.
1. The U.S., Europe and the Emerging Markets
The convertible market was valued by BofA Merrill Lynch at $289.5 billion (USD) at December 31, 2016. While the U.S. dominates the market, convertibles have become a global asset class, supported by encouraging issuance trends worldwide.
We believe that the green shoots of European economic recovery can serve as a catalyst for issuance, as companies repair their balance sheets and invest for growth. The size of the emerging market convertible market remains relatively small. However, we expect opportunities to grow over time as (1) EM economies continue to prosper, (2) their capital markets mature and (3) EM companies rely less on bank financing.
2. The Opportunity in Non-rated Issues
Non-rated issues make up about one-half of the global convertible market. Often, companies forego having their securities rated at the outset, avoiding a lengthy and expensive process. This can provide a significant opportunity for an experienced asset manager.
Interestingly, there has not been a wide disparity among the default rates of investment grade, non-investment grade and non-rated convertible issues.
3. Issuance, Interest Rates and Performance
There’s a connection between interest rates and convertible securities issuance.
While economic growth is the most important factor driving issuance, rising interest rates can provide a catalyst. Because convertible securities provide the opportunity for upside equity participation, they can be offered with lower coupons than non-convertible debt.
Consequently, convertibles may be an especially attractive way for a company to access the capital markets when interest rates are high.
4. An Equity Alternative for the Full Market Cycle
Convertibles are an equity alternative that have captured more upside in bull markets than downside in bear markets.
5. The Difference An Active Manager Can Make
Convertibles have varying degrees of equity and fixed income sensitivity, and these characteristics may change for a given convertible over time, as suggested in the table below.
The table illustrates why convertible strategies must be actively managed to maximize their potential benefits. The most equity-sensitive convertibles may not provide adequate downside protection, while the most bond-like convertibles may not offer sufficient equity upside participation. By contrast, passive strategies cannot adjust to changes in either an individual convertible’s characteristics or to the characteristics of the convertible universe as a whole.
What you’ll find in Convertible Securities: Structures, Valuation, Market Environment and Asset Allocation:
1. Introduction to Convertible Securities
- What is a convertible bond?
- What is a convertible preferred stock?
- What is a mandatory convertible?
- What are exchangeable convertible bonds and exchangeable convertible preferred stocks?
- Where do convertible securities fit within the capital structure?
- What is a synthetic convertible?
2. Factors Driving Convertible Issuance
- Why do companies issue convertibles?
- What macro factors drive convertible issuance?
3. A History of the Convertible Market
- When did companies first issue convertible bonds?
- What were some of the key trends in the convertible market in the twentieth century?
- How has the convertible market evolved in the twenty-first century?
4. Valuing a Convertible Bond
- What is the investment value?
- What is the investment premium?
- What is the conversion price?
- What is the conversion ratio?
- What is the conversion value?
- What is the conversion premium?
- What is the relationship between conversion value and investment value?
- What are the different types of convertible call provisions?
- What antidilution protections do convertible bonds carry?
5. Performance of Convertibles in Various Environments
- How have convertibles historically performed versus equities and corporate bonds?
- How have convertibles performed in up and down markets?
- How has the performance of investment-grade and speculative-grade convertibles differed over time?
6. Characteristics of the Global Convertible Market
- How large is the global convertible market?
- What is the regional composition of the global convertible market?
- What are the credit characteristics of the convertible market?
- How frequently have there been defaults in the U.S. convertible bond market?
7. Convertibles and Asset Allocation
- In what ways can convertibles be used within asset allocations?
- Why do convertibles require active management?
- How should convertibles be managed within a core/strategic allocation?
- How can convertibles be incorporated as tactical allocations?
- What are the potential limitations of a convertible allocation invested exclusively in investment-grade credits?
Financial advisors, for more information on any of the Calamos funds that use convertible securities, please see the Related Funds section or talk to your Calamos Investment Consultant at 888-571-2567 or [email protected].