Performance
The first two months of the fourth quarter saw stocks and equity-linked convertible bonds soar in the wake of the U.S. elections. Smaller caps continued their outperformance that began in late summer which served to propel the U.S. convertible market, which has few mega-cap companies among its constituents. During the first two months of the fourth quarter, the U.S. Convertible Index1 rose 7.67% which bested the 4.90% return of the S&P 500 and the 5.77% return of the NASDAQ Composite over the same period. Much of the convertible market’s strong performance is result of the performance of small cap stocks as evidenced by the 9.37% return of the Russell 2000 Index in October and November. In addition, the U.S Convertible Index benefitted from the tremendous advance of its largest constituent, MicroStrategy. The common shares and convertible bonds of MicroStrategy, a company with a small software business, whose main asset is its holding of Bitcoin, surged following the election on the expectation that the new administration would impose fewer regulations on cryptocurrencies.
The convertible market’s advance in the fourth quarter puts the year-to-date upside capture of the equity markets closer in line to historical norms of 60-80%. Through the end November, the U.S Convertible market has participated in approximately 56%, 54%, and 73% of the upside moves in the S&P 500, NASDAQ, and Russell 200 Indices, respectively (Source: Bloomberg).
Issuance
Issuance of convertible securities for the eleven months of 2024 has been strong, with $71.8 billion of new issuance coming to the market (source: Bank of America). Higher interest rates and a coming wave of maturing debt has companies searching for less costly avenues to refinance that debt. In addition, with stocks at record levels, many managements are comfortable issuing a security linked to their share price. Higher rates, however, have been the main 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, several large offerings from a few companies have helped to increase year-to-date issuance. In October, Boeing issued $5 billion of convertible shares in an attempt to improve its balance sheet profile. In November, the aforementioned MicroStrategy issued $3 billion of zero coupon convertible notes, using the proceeds to purchase additional Bitcoin.
Our expectation is that issuance will reach $90 billion this year as December has seen at least ten new issues come to market as companies rush to raise capital before yearend. This compares to $53.4 billion of new issuance in 2023 and $28.7 billion of new issuance in 2022. 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.
Positioning and Outlook
While the economy seems reasonably healthy, we are not incorporating any macro-economic views into our investment decisions, as our investment process is focused on company-specific fundamentals. We do have concerns about the valuations accorded to many listed equities. Stocks were trading at relatively high multiples of earnings and cash flow before the November election and their subsequent advance is hard to justify even taking into account the possibility of lower corporate tax rates and a generally more business-friendly climate. Given the current rate of core inflation and the yield on risk-free Treasuries, it is difficult to rationalize equity valuations. Our positioning has us over-weighted sectors such as Healthcare and to a lesser extent, Energy, where we find decent fundamentals and attractive valuations based on free cash generation. These sectors have been a drag on relative performance in the fourth quarter as investors have bid up securities that are expected to benefit most from a Trump presidency. Our experience has shown that positioning based on who occupies the White House has a way of not turning out as expected. While our current positioning and its impact on performance has been frustrating, we have been through periods such as this before, most notably in the late 1990’s and 2020, and we believe that our process which emphasizes strong company fundamentals and reasonable valuation will outperform over a complete market or economic cycle.
1. The ICE BofA All U.S. Convertibles (VXA0) Index. See index descriptions below
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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
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USE OF ISSUER NAMES
All security, issuer and company names cited herein are done so for informational purposes only. The securities, issuers and companies cited herein are only intended to convey factual information and current market conditions. Such names are not intended, nor should they be construed as, a recommendation to buy and sell any individual security nor as an indication of current or future profitability. Issuers cited herein do not necessarily represent portfolio positions of MacKay Shields or its affiliates, nor does the firm express any views, positive or negative, on such issuers.
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
MacKay Shields LLC is a wholly owned subsidiary of New York Life Investment Management Holdings LLC, which is wholly owned by New York Life Insurance Company. "New York Life Investments" is both a service mark, and the common trade name of certain investment advisers affiliated with New York Life Insurance Company. Investments are not guaranteed by New York Life Insurance Company or New York Life Investments.
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