Historically, convertible bonds have been an overlooked asset class, but they gained the spotlight in 2020 and 2021, a position they continue to enjoy in 2023. According to Advent Capital Management, an $9 billion institutional investment manager focused on credit, convertible bonds delivered alpha last year when other fixed income asset classes failed.
In fact, convertibles captured only 52% of the negative return racked up by their underlying equities.
Tracy Maitland of Advent Capital believes the structural alpha offered by convertibles is critical and especially relevant during this period of extreme volatility and uncertainty. In a recent interview with ValueWalk, he explained why he sees convertible bonds as a “way to win by not losing.”
Educating Investors About Convertible Bonds
Maitland said he started Advent Capital in 1995 after leaving Merrill Lynch. Maitland said Merrill Lynch’s convertibles unit was the most popular for a time, managing 70% of its capital because of how profitable the asset class was. As the convertibles market grew, he began to talk to pension funds and other institutional investors about the asset class and decided to start Advent – a firm emphasizing convertibles.
“I wanted to help educate folks on the value-add of convertibles back then, and still today, it’s a very overlooked asset class despite its track record of superior performance with less risk since 1973,” Maitland explained.
“I think it’s just an overlooked asset class,” Maitland said. “It’s not in The Wall Street Journal every day. It’s not on CNBC every day. Investors don’t know about it. Few securities offer the positive asymmetry that captures most of the upside with only a portion of the downside risk. “
The Right Time For Convertible Bonds?
He believes convertibles are particularly attractive during more challenging economic environments like the current one, which is marked by increased volatility stemming in part from global geopolitical issues. Maitland explained that the yields on convertible bonds have gone up just like they have on other fixed-income securities.
Many convertibles currently yield between 3% and 4% four to seven years, which he said is attractive. He added that convertibles limit downside risk should the underlying equity decline but they also offer a positive rate of return if the stock goes up. As a result, investors in convertibles capture most of the upside, but if the stock goes down, they get their money back at maturity with an attractive rate of return.
“That’s one reason why I think they’re interesting to both institutional and individual investors today, but most don’t know about them,” Maitland added. “I would argue also if everybody knew about convertibles, they wouldn’t have the risk/reward that they do. It’s a little balancing act to raise the profile of convertibles so investors understand the value-add of the asset class over time.”
He also feels convertibles are more interesting today than they’ve been in quite some time. Of course, during the extended period of free money, the yields on convertibles weren’t as good as they are today. Maitland added that convertibles have an embedded equity option so as the stock becomes more valuable, the option also becomes more valuable.
Why Maitland Likes Convertible Bonds
Maitland chose to focus on convertibles at Advent Capital because while he was at Merrill Lynch, he had the benefit of rotating throughout the firm’s various divisions over two years. He spent time in the firm’s investment banking, securities research, trading desk, and other divisions.
“I got to see a lot of things before deciding what made sense,” Maitland said. “I rotated through convertibles, I thought, ‘Hey, this is interesting to think about.’ If you’re a fairly wealthy investor, it’s not about getting rich. It’s about staying rich and safety of principal.”
He added that when convertibles aren’t working, they still offer income and downside protection versus equities.
“If you look today, a lot of convertibles are small- or mid-cap companies trading at a discount to S&P 500 companies,” Maitland said. “So right now, they are trading at a discount, and normally small-cap trades are more in line with the S&P 500. So, to me, investors can pick up three to four turns of multiple expansion by investing in small-cap or mid-cap companies as their valuations normalize versus the S&P 500.”
The Advantages Of Convertibles
He added that when the underlying stocks associated with convertible bonds are trading at a discount to the S&P 500, investors not only benefit from the normalization of the stock price but also from the other characteristics of convertibles.
Maitland feels convertible structures are better today than they were in 2020 because interest rates were low then, but now they’re up to 3%, 4% or even 5%. He sees opportunities in buying more attractive convertibles now because they tend to grow faster than companies included in the S&P 500.
“I’m excited about where we are today, as convertibles are well positioned to weather the storms of volatility in the marketplace,” Maitland said. “For an individual investor, if there is volatility on a coupon-paying bond, the average maturity is four years. As long as the credit work is done properly, I can sleep better at night knowing I have convertibles in my portfolio. If something goes wrong, credit-worthy companies have little downside risk. The positive rate-of-return story should resonate with both individual and institutional investors.”