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Convertible Bond Investing Brochure (PDF)

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Convertible Bond Investing Brochure (PDF) Convertible bond investing Invesco’s Convertible Securities Strategy 1 Introduction to convertible bonds A primer Convertible securities provide investors the opportunity to participate in the upside of stock markets while also offering potential downside protection. Because convertibles possess both stock- and bond-like attributes, they may be particularly useful in minimizing risk in a portfolio. The following is an introduction to convertibles, how they exhibit characteristics of both stocks and bonds, and where convertibles may fit in a diversified portfolio. Reasons for investing in convertibles Through their combination of stock and bond characteristics, convertibles may offer the following potential advantages over traditional stock and bond instruments: • Yield advantage over stocks • More exposure to market gains than market losses • Historically attractive risk-adjusted returns • Better risk-return profile • Lower interest rate risk Introduction to convertibles A convertible bond is a corporate bond that has the added feature of being convertible into a fixed number of shares of common stock. As a hybrid security, convertibles have the potential to offer equity-like returns due to their stock component with potentially less volatility due to their bond-like features. Convertibles are also higher in the capital structure than common stock, which means that companies must fulfill their obligations to convertible bondholders before stockholders. It is important to note that convertibles are subject to interest rate and credit risks that are applicable to traditional bonds. Simplified convertible structure Bond Call option Convertible Source: BofA Merrill Lynch Convertible Research. The bond feature of these securities comes from their stated interest rate and claim to principal. Like any fixed income instrument, the bond’s value depends on its creditworthiness, yield and time to maturity. The stock feature is derived from the embedded call option that allows the convertible bond to participate in stock appreciation. As such, the option value is tied to factors affecting the underlying stock price. Factors that affect the embedded option include stock price movement and the amount of time left on the option. As market movements increase, the probability that the underlying stock price will appreciate also increases, which results in a higher value assigned to the option portion of the convertible bond. The longer the amount of time left on the option, the higher its value. Data as of Dec. 31, 2016, unless otherwise stated. 1 Exhibiting stock- and bond-like behavior Convertible bonds exhibit the characteristics of both stocks and bonds. Among convertibles, there’s a spectrum. At issuance, the bond is typically a balanced, total return convertible that has a favorable upside/ downside profile. Balanced convertibles are typically characterized by moderate yields, stock price sensitivity and conversion premiums – the percentage by which the bond price exceeds the value of the underlying stock or “parity” (stock price x number of shares into which the bond converts). This type of convertible is illustrated in the center of the chart below. If the underlying stock moves higher, the convertible exhibits more stock-like characteristics, including lower yields, greater stock price sensitivity, and lower conversion premiums. This ”in the money” convertible is illustrated in the right-hand section of the chart below. On the other end of the spectrum, if the underlying stock sells off, the convertible should exhibit more bond- like characteristics, have a higher yield and conversion premium, and have less downside risk than the common stock. This “out of the money” convertible is illustrated in the left-hand section of the chart below. Convertibles’ characteristics change when the price of the underlying stock rises or falls • Conversion premium Convertible price curve Delta < 0.40 Delta > 0.80 Convertible price Convertible Parity Investment value Stock price Yield instrument Total return instrument Equity alternative Source: BofA Merrill Lynch Convertible Research. For illustrative purposes only The balanced bond/total return part of the spectrum may be considered the “sweet spot” of convertible investing. Here convertibles historically demonstrate less risk relative to their common stocks — that is, they have typically participated in a greater portion of the underlying stock’s upside than its downside. Moreover, downside participation is limited given the convertible’s fixed income attributes – an income stream in the form of a regular coupon or dividend along with repayment of principal at maturity or in the event of a put or call (unless the issuer has defaulted or entered bankruptcy proceedings). In the chart above, those bond-like instruments would likely be more credit sensitive, whereas stock-like instruments would tend to fluctuate more with the price of the underlying stock. Definitions of convertible terminology Investment value: The value of the convertible bond if it were simply a traditional bond without a conversion feature. Acts as the “bond floor.” Parity: Also known as the “conversion value,” this is the stock’s current price times the predetermined number of shares for which the convertible bond may be converted. This set number of shares is also referred to as “the conversion ratio.” Conversion premium: In the chart above, it is represented by the shaded area. It is the amount by which the convertible bond price exceeds parity (the conversion value). It is expressed as a percentage. Delta: A measure of the convertible bond’s price sensitivity to underlying stock price movements. Convertible bond investing through Invesco’s Convertible Securities Strategy 2 Five reasons for investing in convertibles 1. Yield advantage over stocks Convertibles have historically provided a yield advantage over equities. As of Dec. 31, 2016, the US convertibles market, as measured by the Bank of America Merrill Lynch US Convertible Index, had an average yield of 3.15%,1 representing a 170 basis point advantage over its underlying equities. In addition, convertibles are senior to equities in the capital structure. 2. Potentially more exposure to market gains than market losses Over various market cycles, convertibles have historically captured more of the equity market’s upside due to their embedded call option, while providing a measure of downside protection due to their bond-like characteristics. Convertibles performance During bull, bear, recovery and full market cycles • BofA Merrill Lynch US Convertible Index • NASDAQ Composite Index • S&P 500 Index • Russell 2000 Index Annualized Bull market Bear market Recovery Full market cycle return (%) 10/02-9/07 10/07-2/09 3/09-12/16 10/02-12/16 25 20 15 11.19 11.29 9.57 8.57 19.00 18.93 18.80 10 18.20 17.76 15.50 14.31 5 13.30 0 -5 -10 -15 -20 -25 -29.73 -30 -37.83 -38.84 -35 -39.27 -40 Source: StyleADVISOR, Zephyr. As of Dec. 31, 2016. Past performance cannot guarantee future results. Index returns do not reflect any fees, expenses or sales charges. An investment cannot be made in an index. 3. Historically attractive risk-adjusted returns Convertibles have historically outperformed equities over various time periods with substantially less volatility, offering an attractive risk-reward profile versus equities. One way of measuring a risk profile is using beta, which measures the magnitude of share price fluctuations in relation to a specified index. Versus equity indexes such as the S&P 500 Index, NASDAQ Composite and Russell 2000 Index, convertibles exhibit a lower beta over various time periods. Less risk vs. equities As measured by beta2 1 year3 3 years 5 years 10 years 15 years BofA Merrill Lynch® US Convertible Index 0.45 0.45 0.49 0.55 0.52 S&P 500® Index 0.63 0.54 0.59 0.70 0.67 NASDAQ Composite Index 0.76 0.65 0.72 0.81 0.84 Russell 2000® Index 1.00 1.00 1.00 1.00 1.00 Source: Zephyr, StyleADVISOR, Lipper Inc. As of Dec. 31, 2016. Past performance cannot guarantee future results. An investment cannot be made in an index. 1 Source: BofA Merrill Lynch 2 Beta values shown are for the indexes versus the Russell 2000 Index. 3 Beta for 1 Year was calculated on a daily basis. 3 Looking back, convertibles have exhibited comparable behavior to either common stock or bonds over complete market cycles. The chart on the following page shows cumulative total annual returns going back to 1980 for stocks, convertibles and bonds. Since 1980, convertibles have outperformed bonds while participating in the equity market’s upside Cumulative total returns since 1980 • BofA Merrill Lynch US Convertible Index • BofA Merrill Lynch High Yield Master Index • S&P 500 Index • BofA Merrill Lynch Corp./Gov’t. Master Index Percent (%) 1980 1985 1990 1995 2000 2005 2010 2016 6,000 5,588 5,000 4,000 3,865 3,000 2,658 2,000 1,488 1,000 0 Source:-500 Bank of America/Merrill Lynch Convertibles Research, as of Dec. 31, 2016. Past performance cannot guarantee future results. Index returns do not reflect any fees, expenses or sales charges. An investment cannot be made in an index. 4. Better risk-return profile Convertibles may improve the risk-return profile of multi-asset class portfolios. Historically, adding convertibles to a bond portfolio has “pushed out” the efficient frontier, in other words, creating a portfolio that achieved a higher return with the same level of risk. The inclusion of convertibles to a portfolio of government and corporate bonds can potentially provide investors more return for the same amount of risk when compared to a traditional stock and bond portfolio. Improved risk-return profile (January 2009 - December 2016) • Portfolio of bonds and convertibles • Portfolio of traditional stocks and bonds Return () 17 100 equities 15 100% converts 85% equities, 15% bonds 13 25% bonds, 75% converts 70% equities, 30% bonds 11 50% converts, 50% bonds 9 50% equities, 50% bonds 7 5 100% bonds 3 3 5 7 9 11 13 15 Risk () Source: BofA Merrill Lynch, Invesco from January 2009 through December 2016.
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