Performance
With the U.S. Convertible Index1 (the “Index”) up 1.7% through the first three and a half months of 2024, the asset class is falling short of the traditional 60-80 upside capture of equity returns, but still distinguishing itself from traditional non-convertible bonds which are generally lower for the year-to-date period. Within equities, small cap underperformance has weighed on convertibles which have a large representation of small and mid-cap companies in the universe and a complete absence of mega-cap technology companies, which have been the drivers of S&P 500 and NASDAQ performance.
As smaller and midcap stocks trade at a significantly lower valuation to large cap equities, our expectation is that a narrowing of the valuation gap will lead to improved convertible performance relative to the S&P 500 and NASDAQ indices, and an improvement in upside return capture. In addition, a broadening of the equity rally beyond information technology shares should help the performance of our portfolio which has an overweight to the Healthcare and Energy sectors.
Issuance
Issuance of convertible securities for the first quarter has been particularly strong with approximately $20 billion of new issuance coming to the market. A wave of maturing debt has companies searching for less costly avenues to refinance that debt. Higher interest rates have been a motivating factor for companies seeking financing in our asset class, as they can usually issue a convertible bond with a meaningfully lower coupon than they would be required to pay in the straight high yield or investment grade market. Lastly, with stocks at records levels, companies are comfortable issuing an equity-linked security.
Our expectation is that issuance will remain at elevated levels for the balance of the year as the factors that drove the first quarter’s surge, namely elevated interest rates and the need to refinance maturing debt, is unlikely to subside. New issuance is generally a positive for the convertible market, as most new securities are priced at a discount to their theoretical fair value and generally trade above the issue price on their first days of trading, providing a small boost to Index returns. In addition, new bonds priced at par are balanced securities that usually offer an asymmetric return profile, whereby the bond will capture a greater percentage of the underlying equity’s upside than downside. Lastly, with higher prevailing interest rates, most new issues are coming to market with higher coupons and lower conversion premiums - the amount that the common stock price needs to go up before it becomes advantageous to convert – than what was prevalent in the post-financial crisis environment of ultra-low interest rates.
With an upswing in new issuance with attractive terms and a rising market that may be on the cusp of broadening its gains, the second half of 2024 may be an interesting time for investors to consider an allocation to convertible bonds.
[1] The ICE BofA All U.S. Convertibles(VXA0) Index. See index definition at the end of this document.
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This material contains the opinions of certain professionals but not necessarily those of MacKay Shields LLC. The opinions expressed herein are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and opinions contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Any forward-looking statements speak only as of the date they are made and MacKay Shields assumes no duty and does not undertake to update forward-looking statements. No part of this document may be reproduced in any form, or referred to in any other publication, without express written permission of MacKay Shields LLC. ©2024, MacKay Shields LLC. All Rights Reserved.
Past performance is not indicative of future results.
NOTE TO UK AND EUROPEAN AUDIENCE
This document is intended only for the use of professional investors as defined in the Alternative Investment Fund Manager’s Directive and/or the UK Financial Conduct Authority’s Conduct of Business Sourcebook. To the extent this document has been issued in the United Kingdom, it has been issued by MacKay Shields UK LLP, 80 Coleman Street, London, UK EC2R 5BJ, which is authorised and regulated by the UK Financial Conduct Authority. To the extent this document has been issued in the EEA, it has been issued by MacKay Shields Europe Investment Management Limited, Hamilton House, 28 Fitzwilliam Place, Dublin 2 Ireland, which is authorised and regulated by the Central Bank of Ireland.
NOTE TO CANADIAN AUDIENCE
The information in these materials is not an offer to sell securities or a solicitation of an offer to buy securities in any jurisdiction of Canada. In Canada, any offer or sale of securities or the provision of any advisory or investment fund manager services will be made only in accordance with applicable Canadian securities laws. More specifically, any offer or sale of securities will be made in accordance with applicable exemptions to dealer and investment fund manager registration requirements, as well as under an exemption from the requirement to file a prospectus, and any advice given on securities will be made in reliance on applicable exemptions to adviser registration requirements.
COMPARISONS TO AN INDEX
Comparisons to a financial index are provided for illustrative purposes only. Comparisons to an index are subject to limitations because portfolio holdings, volatility and other portfolio characteristics may differ materially from the index. Unlike an index, portfolios are actively managed and may also include derivatives. There is no guarantee that any of the securities in an index are contained in any managed portfolio. The performance of an index may assume reinvestment of dividends and income, or follow other index-specific methodologies and criteria, but does not reflect the impact of fees, applicable taxes or trading costs which, unlike an index, may reduce the returns of a managed portfolio. Investors cannot invest in an index. Because of these differences, the performance of an index should not be relied upon as an accurate measure of comparison.
SOURCE INFORMATION
ICE Data Indices, LLC (“ICE Data”), is used with permission. ICE® is a registered trademark of ICE Data or its affiliates, and BofA® is a registered trademark of Bank of America Corporation licensed by Bank of America Corporation and its affiliates (“BofA”) and may not be used without BofA’s prior written approval. ICE Data, its affiliates and their respective third-party suppliers disclaim any and all warranties and representations, express and/or implied, including any warranties of merchantability or fitness for a particular purpose or use, including the indices, index data and any data included in, related to, or derived therefrom. Neither ice data, its affiliates nor their respective third-party suppliers shall be subject to any damages or liability with respect to the adequacy, accuracy, timeliness or completeness of the indices or the index data or any component thereof, and the indices and index data and all components thereof are provided on an “as is” basis and your use is at your own risk. ICE Data, its affiliates and their respective third-party suppliers do not sponsor, endorse, or recommend MacKay Shields LLC, or any of its products or services.
ABOUT RISK
Convertible securities are subject to a risk of loss. Convertible securities may be subordinate to other securities. The total return for a convertible security depends, in part, upon the performance of the underlying stock into which it can be converted. Additionally, an issuer may encounter financial difficulties which could affect its ability to make interest and principal payments. If an issuer stops making interest and/or principal payments, an investor could lose its entire investment.
The following indices may be referred to in this document:
The ICE BofA All U.S. Convertibles (VXA0) Index is an unmanaged index that consists of convertible bonds traded in the U.S. dollar denominated investment grade and non-investment grade convertible securities sold into the U.S. market and publicly traded in the United States. The Index constituents are market value weighted based on the convertible securities prices and outstanding shares, and the underlying index is rebalanced daily.
The S&P 500 Index is an unmanaged index that is widely regarded as the standard for measuring large-cap U.S. stock market performance.
NASDAQ Composite Index: The NASDAQ Composite Index is a broad-based capitalization-weighted index of stocks in all three NASDAQ tiers: Global Select, Global Market and Capital Market.
Russell 2000 Index: The Russell 2000 Index is an unmanaged and market capitalization weighted equity index maintained by the Russell Investment Group that seeks to be a benchmark of the entire US stock market. More specifically, this index encompasses the 2,000 largest US-traded stocks, in which the underlying companies are all incorporated in the US
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