By Philip van Doorn, MarketWatch
Bloomberg
With historically low interest rates, investors are cramming money into stocks, especially in large-cap technology companies including Microsoft Corp. and Facebook Inc.
A simple way to diversify by asset class while cutting risk and benefitting from long-term stock gains is to own convertible bonds.
Dave King, the head of income and growth strategies at Columbia Threadneedle Investments in Boston and a co-manager of the $2.1 billion Columbia Convertible Securities Fund /zigman2/quotes/203789218/realtime NCIAX +0.91% , discussed the sea change in the convertible bond market brought about by the coronavirus, the advantages of the asset class and Tesla Inc.’s /zigman2/quotes/203558040/composite TSLA -0.99% ultra-profitable convertible bond deal.
Not so diversified
The largest exchange traded fund based on an index is the SPDR S&P 500 ETF /zigman2/quotes/209901640/composite SPY -0.52% , which has nearly $294 billion in assets and is weighted to track the S&P 500 /zigman2/quotes/210599714/realtime SPX -0.48% . This means shares of Apple Inc. /zigman2/quotes/202934861/composite AAPL +0.22% , Microsoft /zigman2/quotes/207732364/composite MSFT +1.48% , Amazon.com Inc. /zigman2/quotes/210331248/composite AMZN +1.17% , Facebook /zigman2/quotes/205064656/composite FB +1.15% and Alphabet Inc. /zigman2/quotes/205453964/composite GOOG +0.27% /zigman2/quotes/202490156/composite GOOGL +0.30% make up 22% of the fund’s portfolio.
You might look to diversify further by shifting some of your portfolio s into foreign or emerging-market ETFs, but those may also be highly weighted to a small group of companies.
You can diversify your portfolio and even cut your risk is by holding shares in a convertible securities fund or ETF.
Some side benefits: attractive long-term growth potential, downside protection and a decent dividend yield.
You are probably well aware that the cap-weighting for the S&P 500 has worked to its advantage during the years following the post-credit-crisis bottom on March 9, 2009. But check out this 20-year chart through June 30, comparing the benchmark’s performance and volatility with that of the ICE BofA U.S. Convertibles Index and the Bloomberg Barclays U.S. Aggregate Bond Index:
Columbia Management Investment Advisors, LLC, with data provided by ICE BofA and Zephyr Style Advisor.
The convertibles came out ahead of the S&P 500, with lower volatility, measured by standard deviation.
Most of the gains with less risk
A convertible bond is one that can be converted into the issuing company’s common shares at a stated price or ratio per $1,000 borrowed. Preferred shares can also be issued with convertible features.
An example of a convertible issue was provided by Workhorse Group Inc. /zigman2/quotes/207314632/composite WKHS -14.31% on Oct. 12.
The manufacturer of electric delivery vehicles issued $200 million in 4% convertible notes to institutions. The notes mature in four years and can be converted to common shares at a price of $36.14, which is a 35% premium to the stock’s closing price Oct. 9. In an interview, King said a 4% yield with a maturity of five years or less was typical of the current market for high-yield bonds, or junk bonds — those with ratings below BBB.
Some high-yield bonds aren’t rated at all. In that market, King explained, the unrated paper is considered “nuclear waste.”
But in the convertible market, “it is common for companies not to be rated. Often they are not rated because a company has traditionally had no debt. This is not commonly understood,” King said.
He added that the market’s lack of understanding of convertibles, or even the lack of patience among some investors to wait for a share price to rise after buying convertible bonds, creates opportunities for him to scoop up convertibles at attractive prices.
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