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Markets Update: Convertible Securities
Hi, my name is James Dinsmore and I am a portfolio manager for the convertible strategies here at Gabelli.
2020 has brought massive change and volatility to equity markets, with investors working remotely trying to digest what the long-term implications of COVID 19 are for the economy. While the monetary and fiscal response to this crisis have been swift and massive, any recovery or return to normal could take significant time. These unprecedented times have highlighted some of the benefits of investing in convertible securities.
Convertibles are a way to gain equity exposure with reduced volatility. Over longer time horizons we have seen that they can perform in line with broader equity indices with ¾ of the volatility. They can do this because they offer a yield advantage over common equities, are higher in the capital structure and offer relatively short-term maturities that help to reduce downside exposure in times of distress. Year to date through April 24th, Convertibles have seen less than half of the downside of the S&P 500 and only 43% of the downside of their underlying equities.
While this reduced downside participation has been an important part of the convertible story this year, equally important has been the ability of companies to issue convertibles to improve their balance sheets and liquidity for uncertain times. Convertible issuance this year is on pace to be at the highest level since 2007. Many companies in the Consumer Discretionary sector have turned to convertibles to shore up liquidity for a zero-revenue environment. Some of the terms have been quite attractive to us as investors, while being significantly less onerous to issuers than the high yield market. In past downturns, this type of financing has allowed companies to survive demand shocks and emerge stronger as demand eventually recovers. Recent issues from companies such as Booking Holdings, Southwest Airlines, and even Carnival Cruise Lines fit this mold and have been well received by the convertible market. We have also seen companies issuing convertibles for potential acquisition at much better terms than we would have seen just a few months ago.
This issuance offers us great opportunity. The convertible market has grown and diversified significantly this year. The terms are more attractive, with higher yields and lower premiums. Many existing issues are trading at levels where we can invest with a reasonable expectation of yield to maturity with potential for upside if the economic recovery happens more quickly than anticipated. There are opportunities to gain risk adjusted equity exposure to companies whose business models can generate recurring revenues and growing cash flows regardless of the shape of the recovery. With this attractive mix of issues, we can position our portfolios for total return through a mix of income and capital appreciation, with an asymmetrical profile that will participate in more of the underlying equity upside than downside.
