If you haven’t heard of convertible bonds before, don’t be surprised – as the FT’s Matthew Vincent points out, these instruments have “long been overlooked in the UK as an asset class for uncertain times”. This is a pity as they have outperformed both conventional bonds and equities on an annualised basis over the past ten years.
In 2007, convertible issuance hit an all-time high of $183bn, up 47% on 2006 as firms struggled to raise debt capital in the wake of the credit crunch, and investors demanded instruments capable of profiting from market volatility and uncertainty. Like any other corporate bond, convertibles offer regular interest and a redemption payment. The added attraction for investors is the possibility of exchanging the bond at a later date for a predetermined number of shares, which offers an investor the bonus of benefiting from a strong rise in an issuer’s share price.
The caveats are firstly that this option to convert is usually only available on a limited number of future dates, and only then provided the issuer’s share price hits a preset minimum target level – often set substantially above the current share price. So a bond with a 10:1 conversion ratio issued when a firm’s share price is £50 could make a £100 profit should the share price hit a target of, say, £60. But a major trade-off for the potential conversion upside is lower income (yields, at just under 4%, are below gilts just now) and then there’s the fact that in an equity bull market you’re better off simply holding shares.
Nonetheless, the regular income stream on offer, coupled with prospective gains from future conversion (if the share price rises, so does the value of the bond) is attracting savvy investors. Bestinvest’s John Davey sums up why: “Converts have historically offered 71% of stockmarket returns but only 52% of downside risk”. That’s an attractive profile when market conditions look choppy.
So, what to buy? Convertibles are relatively complex instruments, combining conventional bonds with options, so the easiest route in is via a fund such as the new JP Morgan Global Convertibles (0845-246 1850). The fund’s forerunner, the JP Morgan Luxembourg fund, has returned 5.91% a year over the past three, says the FT. Alternatively, Davey recommends the US-focused M&G Global Convertibles fund (0800-390390).