Performance
At the end of July, the ICE BofA All U.S. Convertibles Index (the “Index”) had advanced more than 11% from the start of the year. Just three months later, the Index was up less than one percent. Adding to the frustration has been the relatively poor performance of the Index versus the S&P 500 and NASDAQ to which the Index is usually closely correlated. Both equity indices have benefitted from the strong performance of a handful of their largest respective constituents. The broader and more small- cap focused Russell 2000, which may be a better reflection of many companies with convertible bonds outstanding, is roughly flat for the year. Our expectation is that the performance gap between the Russell 2000 and the larger cap indices will narrow.
On a positive note, convertibles have performed far better than traditional straight bonds, highlighting their correlation to equities and historical negative correlation to interest rates. In addition, with data suggesting that inflation may have peaked, our expectation is that the advance in equities can broaden out to include more of the issuers in the convertible universe. With valuations on smaller cap companies far lower than their larger cap peers, we expect that, in the absence of a durable recession, equity advances will include a greater number of small and mid-cap companies, allowing convertibles to make up ground with the large cap equity indices.
Issuance
Year-to-date, new issuance of convertible securities is well ahead of last year’s pace but still below the pace we saw in 2020 and 2021. Through the end of October, new issuance totaled just under $44 billion which is nearly twice the total for all of 2022.[1] At the current rate, we expect this year’s new issuance to approximate $50-55 billion which is within the range of historical norms. Higher interest rates should continue to incent companies to raise capital in the convertible market as they can issue debt with a much lower coupon by providing investors the potential for upside appreciation tied to the issuer’s stock price through the bond’s conversion feature.
For investors, nearly 20% of the new convertible issuance this year has been investment grade, 1 which was incredibly scarce for the past decade as investment grade companies could sell non-convertible debt with coupons below 3%. In addition, higher rates have forced issuers to attach larger coupons to their convertible offerings. While convertible coupons remain well below those of high-yield debt, they are significantly higher than they were just one year ago. Lastly, the conversion premiums for most new issues – the amount that the common stock price needs to rise before it becomes advantageous to convert – have returned to more historical norms of 25-35% following 2021’s premiums of 50-70% for many large technology and media new issues. 1 These features – lower conversion premiums and higher coupons - should allow investors to capture a greater portion of the underlying equity’s upside move and garner an enhanced income stream versus what might have been earned in recent years past.
Outlook
Fresh economic data continues to suggest that inflation has peaked. If this trend persists, it is likely that equity-linked securities such as convertible bonds may finally be able to break out of the trading range they have been stuck in for the past ten months. Equity valuations, particularly for many small and mid-cap companies, are low enough that they may even be discounting a mild to moderate recession. Barring a deeper economic contraction, we believe these securities are poised to outperform in the coming quarters.
We strive for our bottom-up process, which focuses on companies with a strong fundamental business, free cash flow and a solid balance sheet. to perform well in most market environments. In addition, by utilizing the asymmetric return profile inherent in most balanced convertible bonds, whereby an investor may participate in a greater percentage of the issuer’s equity upside than downside, we feel we are well positioned for the year ahead.
[1] Source: ICE Data.
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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. ©2023, MacKay Shields LLC. All Rights Reserved.
Past performance is not indicative of future results.
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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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