Don’t Convert to Convertible Bonds

Equity exposure in disguise

September 2023. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • Convertible bonds are typically viewed as debt rather than equity instruments
  • However, these are highly correlated to equities
  • The diversification benefits are limited as these just represent diluted equity proxies

INTRODUCTION

Let’s say you’re the CEO of a small listed company that isn’t doing well. The stock price of your company is depressed, so issuing equity would be highly dilutive. The debt rating is below investment grade, so you could only sell high-yield bonds, which will be another drag on the cash flow. Mezzanine debt means dealing with shark-like private equity professionals, so is not a great option either.

What about issuing convertible bonds? The yield on these would be low compared to high-yield bonds, and they can be recalled and swapped for traditional debt when the company’s outlook has improved. Let’s do it!

On the face of it, convertible bonds seem to be more attractive for the issuer than the investor. Is that true?

In this research article, we will evaluate the investment case for convertible bonds.

CONVERTIBLE BOND ETFS

First, we review the performance of convertible bonds in the US ETF space, where there are only four products with meaningful assets under management.

The SPDR Bloomberg Convertible Securities ETF (CWB) has been trading since 2009, manages $4.6 billion, and charges 0.4% per annum. BlackRock launched the iShares Convertible Bond ETF (ICVT) in 2015 with a 0.2% management fee and gathered $1.5 billion of assets. The First Trust SSI Strategic Convertible Securities ETF (FCVT) and American Century Quality Convertible Securities ETF (QCON) have negligible market shares with $93 million respectively $24 million of assets.

FCVT and QCON are actively managed funds, while CWB and ICVT track convertible indices calculated by Bloomberg. These indices focus on convertible bonds that are liquid and have raised at least $250 million from investors.

We observe that the performance of these four ETFs was comparable, with QCON outperforming and FCVT underperforming the passive products. Convertible bonds had a drawdown larger than 30% during the COVID-19 crisis in 2020, but then generated signif