Schroders Convertible Bonds
Owning an option on the upside
Convertible bonds (CBs) are still a little-known part of the market for many investors. We think that is a shame, as we would argue that CBs can form a surprisingly versatile element in many portfolios. This article aims to provide an introduction to CBs for the uninitiated, while helping more knowledgeable investors to deepen their understanding.
CBs are hybrid securities which entitle the investor to convert a bond into a certain number of associated shares. In this they combine some of the characteristics of fixed income instruments and some of equities. In particular, their ability to participate in equity upside while providing bond-like protection on the downside makes them attractive compared to other asset classes. Many studies1 have confirmed these characteristics for different markets and time periods. The history of CBs goes back to 1843, when the city of New York and Erie Railroad issued the first such bond to finance railway lines in the United States, but it is only in recent years that CBs have started to become a popular asset class.
The market for CBs is still quite small compared to those for other asset classes, such as equities or bonds. Nevertheless, it is well diversified geographically and is an established source of funding for both medium-sized and large companies. The market was valued at $325 billion by the end of July 2016, having shrunk since its peak in 2007 as maturing bonds have outpaced new issues (Figure 1). The US is still the leading issuing region, followed by Europe and Asia. Moreover, the US has increased its market share from 22% in 1995 to 51% in 2015, while Japan has seen its share fall from 51% to just 6% over the same period2.
1 For example Scott L. Lummer and Mark W. Riepe, “Convertible Bonds as an Asset Class: 1957–1992”, Journal of Fixed Income 3, no. 2, 1993; and Angelo Ranaldo and Alain Eckmann, “Convertible Bonds: Characteristics of an Asset Class”, UBS research paper, 2004.
2 Thomson Reuters, 2016.