Convertible Bond Funds: Equity market returns with less risk?

convertible bond funds

Convertible bond funds, are bond mutual funds and ETFs that invest in bonds which can be converted into stock at a fixed price.  If the stock does well, convertible bondholders benefit.  On the other hand, if the company goes into bankruptcy, convertible bondholders will recover more funds than the firm’s stockholders.

Investors want to be able to take part in an equity market rally without feeling the pain should the market collapse again.  With the S&P 500 nearing levels not seen since late 2008, there is a growing anxiety that a potential crash is around the corner.  On the other hand, the incredibly low yields offered on bonds, which are the main alternative to stocks, are unattractive.  As a result of the above quandary, many investors are looking to convertible bond funds.

Sounds great, but there is a cost.  The bonds that convertible bond funds invest in are normally issued by companies with non-investment grade credit ratings, or no credit rating at all.  However, because they are convertible to stock if things go well, they pay a much lower yield than high yield bonds which are not convertible.

Do convertible bond funds deliver stock fund like returns?

Yes. (You know a “but” is coming)

From January 1995 to May 2011, returns from investing $100 in US equities and $100 in the average US convertible bond fund would have delivered almost the same returns.  Both would have been worth around $400.

Convertible bond fund returns tend to  trail stock market returns during bull markets by about 15-20%. However, convertible bond funds also tend to drop less than stocks during market declines. For example, according to Invesco, during the market crash from October 9, 2008 – March 9th, 2009, stocks declined 55%.  Convertible bond funds on the other hand,  were down 43%.

If the performance of the last two decades holds true, the average convertible bond funds will provide equity like returns with less volatility than stocks.

However, interest rates have been falling consistently for the last two decades.

In January 1995, the interest rate on 10 year treasury notes was a hair below 8%.  Today it is below 2%.  When interest rates decline, the value of bonds rise.  The reverse is also true. The biggest risk to most bondholders is rising interest rates.  Should interest rates move higher for an extended period, then convertible bond funds might significantly underperform stocks.  In fact, convertible bond fund performance could even turn negative as a result.

However, your fund may not behave like other convertible bond funds.

Performance can vary greatly from one convertible bond fund to another.  A convertible bond fund analyst must be able to evaluate the upside and downside of a company, interest rate and macroeconomic conditions.  With Convertible bond funds, there is much more room for the portfolio manager to have a distinct market view that differs from other managers.

There are not that many convertible bond funds.  Morningstar only has data for 48 convertible bond funds for the last five years, and 86 funds as of 2012.  The numbers are actually smaller than that, because the data also includes different share classes of the same fund. Once you remove the different share classes, there are perhaps only 20 different convertible bond funds. The worst convertible bond fund tracked by Morningstar has an average annual return of -3.38%, and the best 5.54%, over the last five years.

As each fund will get inflows of capital at different times and the availability of bond inventory / new issues can be unpredictable, the holdings of similarly minded portfolio managers can be very different.

The Bottom Line

I have tremendous concern about how convertible bond funds will perform during periods of rising interest rates. Will their performance start to mimic the bond market more than stock market when rates rise? The short answer is that I don’t know, and there really isn’t any great historical data on this subject. When I get uncomfortable, I tend to stay away as an investor.

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