Convertibles in the fast lane

Karen Veraa, CFA Jul 22, 2021

Key takeaways

  • More fast-growing companies are issuing convertible bonds, creating new ways for investors to play the economic reopening.
  • Convertibles blend the features of stocks and bonds — offering stock-like growth potential with bond-like income and downside protection.
  • The iShares Convertible Bond ETF (ICVT) is a low-cost, diversified way to access the U.S. convertible bond market.

Investors are turning to an often overlooked, lower-risk approach to owning fast-growing companies: convertible bonds. These bond/stock hybrid securities offer the potential for price appreciation in rising markets (like a stock) as well as the potential for income and value preservation in down markets (like a bond).

A record number of companies raced to issue convertible bonds to fund operations during a volatile 2020, and this swell of new bond issuance has continued into 2021 as more businesses seek low-cost borrowing to expand into a reopening economy.1 Companies generally pay less interest by issuing convertible bonds compared with traditional ones; bondholders accept less interest but gain an option to exchange debt for common shares.

This dynamic often makes the convertibles marketplace appealing to high-growth businesses in need of capital to expand. Recent first-time convertible issuers include digital payments company Square, music streaming service Spotify Technology, and work communications platform Slack Technologies. Electric vehicle maker Tesla issued convertible bonds numerous times to finance its expansion.2

Fast and furious growth 

The market capitalization (in billions) of the U.S. convertibles market, as measured by an index composed of U.S. dollar-denominated convertible securities, specifically cash pay bonds, with outstanding issue sizes greater than $250 million.

Fast and furious growth

Source: Bloomberg, as of 7/12/2021 using the total market capitalization of the Bloomberg Barclays U.S. Convertibles Cash Pay >$250 mm Index. Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

A crash course in how convertibles work

Convertible bonds pay interest and have a fixed maturity date like traditional bonds. Unlike traditional bonds, they have features that allow bondholders to convert debt into a set number of common stocks at a predetermined price. This feature makes convertibles relatively more sensitive than traditional bonds to the movements in the company’s share price. If the stock price falls, a convertible’s interest and principal payments can help limit losses. If the stock price rises, the convertible bond’s price tends to rise, too. Generally, investors keep a close eye on the conversion parity price — the price above which it makes economic sense for bondholders to exercise their conversion to stock.

How convertible bonds react to changesin issuer's stock price.

Built-in airbags, or potential for downside protection

Consider that between Feb 20, 2020 through March 23, 2020, a period that saw a sharp market drawdown related to the outbreak of Covid-19, Morningstar reports large-blend equity strategies on average fell 34% while the average convertible strategy fell just 24%.3

Convertibles can help diversify fixed income holdings since they historically have exhibited low correlations to core bond funds.4 Additionally, our analysis shows they can potentially guard against rising interest rates and fast-rising inflation, two worries for bondholders at this stage of the economic cycle.5

Changing gears: A different sector focus compared to traditional debt markets

The dividend-growth advantage

Source: Bloomberg Barclays Indices, as of 7/12/2021. Sectors are based on the Bloomberg Barclays Level 3 Industry Definitions. Allocations subject to change.

Where the rubber meets the road

Investors might consider the iShares Convertible Bond ETF (ICVT) to target fast-growing companies while trying to add protection against sharp downward swings and rising interest rates. Since the market for convertibles is relatively small and specialized, ETFs can offer an affordable, convenient way to access what remains a niche market.6

Karen Veraa, CFA

Karen Veraa, CFA

Head of U.S. iShares Fixed Income Strategy

Dhruv Nagrath

Fixed Income Product Strategist