Performance
While convertibles have performed far better than traditional straight bonds, compared to the S&P 500 and NASDAQ indices, convertibles have fallen short of their typical 60-80% upside participation. Much of this shortfall is due to the absence of the best performing S&P and NASDAQ issues from the convertible market. With valuations on smaller cap companies far lower than their larger cap peers, our expectation is that, in the absence of a recession, equity advances will broaden out to include a greater number of small and mid-cap companies, allowing convertibles to make up ground with the large cap 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. At the current rate, we expect this year’s totals 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, more than 20% of the new issuance this year has been investment grade, 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. 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.
Figure 1: Annual New Issuance
Source: MacKay Shields LLC, S&P 500, NASDAQ, and Bloomberg U.S. Aggregate Bond Index
Figure 2: Index Price-Earnings Ratio
Source: MacKay Shields LLC, S&P 500, NASDAQ, and ICE BofA All U.S. Convertibles (VXA0) Index
Outlook
Apart from being confident that prices will fluctuate, we are agnostic in our view of market returns in the coming six to nine months. We believe our bottom up process which focuses on companies with a strong fundamental business, free cash flow, and a solid balance sheet should perform well in most market environments. In addition, by utilizing the asymmetric return profile inherent in most balanced convertible bonds, whereby an investor can expect to participate in a greater percentage of the issuer’s equity upside than downside, our convertible strategy is one you may want to consider.
IMPORTANT DISCLOSURE
Availability of this document and products and services provided by MacKay Shields LLC may be limited by applicable laws and regulations in certain jurisdictions and this document is provided only for persons to whom this document and the products and services of MacKay Shields LLC may otherwise lawfully be issued or made available. None of the products and services provided by MacKay Shields LLC are offered to any person in any jurisdiction where such offering would be contrary to local law or regulation. This document is provided for information purposes only. It does not constitute investment or tax advice and should not be construed as an offer to buy securities. The contents of this document have not been reviewed by any regulatory authority in any jurisdiction.
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.
NOTE TO UK AND EUROPEAN INVESTORS
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 INVESTORS
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.
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.
Bloomberg U.S. Aggregate Bond Index: The Bloomberg U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. Must have at least one year to final maturity regardless of call features. Must have at least $300 million par amount outstanding. Must be rated investment-grade (Baa3/BBB- or higher) by at least two of the following ratings agencies: Moody's, S&P, Fitch. Must bedollar-denominated and non-convertible.
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.
“New York Life Investments” is both a service mark, and the common trade name, of certain investment advisors affiliated with New York Life Insurance Company.
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