Convertibles can offer upside and defence

Convertible bonds have an option that allows investors to swap them for equities in the company which issued the bonds. Because investors get the chance to take part in the growth of the business convertible bonds can be issued with a lower coupon (interest rate) than would otherwise be the case. Convertible bonds are a relatively established area but often inaccessible to private investors outside a fund structure because of the large minimum investments required.

Advocates of this asset class argue that convertible bonds have historically offered higher and more dependable yields than global equities, with their coupons a more secure income source because of their priority in the capital structure. While this asset can offer some of the upside that equities offer in rising markets, they also tend not to fall as much when things are not so good. "In practice, convertibles perform like debt-equity hybrids exhibiting bond like characteristics, providing income in normal and falling equity markets but growing like an equity when share prices rise," explains JPMorgan.

This means they can offer lower volatility than equities. The UBS Global Convertibles Index returned 7.4 per cent on average each year between 1994 and 2012, versus 5.3 per cent for MSCI World (equity) Index and with significantly lower volatility, according to Lee Manzi, co-manager of the Jupiter Global Convertibles Fund (LU0522256048).

10 year convertible bond returns to 31 December 2012

Source: JPMorgan Asset Management, Bloomberg

"With continuing macro-uncertainties in much of the developed world, the investment case for assets which show lower correlation to equities and decent defensive characteristics is enhanced," adds Mick Gilligan, head of research at broker Killik. "We believe there is a strong case for having an allocation to convertible bonds within a diversified portfolio."

The make-up of the convertibles market differs from other markets in terms of sectoral and geographical representation, according to Leonard Vinville, manager of the M&G Global Convertibles Fund. "For instance, it has relatively little exposure to Japan, which fell sharply, but more focus towards the US, which was comparatively stable," he says.

Issuers also include more small and mid-cap companies in contrast to corporate bonds. This means issuers are the sort of companies which can benefit from mergers and acquisitions, and some convertible bond issuers have no other debt.

Anthony Vallee, manager of JPMorgan Global Convertibles Income, says convertible bonds are a good way to access a slightly higher risk company because bonds are higher up the return scale than equities. This is because the event of default bond holders get paid back before equity holders.

Convertibles tend to have relatively short terms to maturity, usually between three and five years. This reduces the sensitivity of convertibles to potential increases in interest rates in comparison to other corporate bonds. Also, the value of the call option embedded within convertibles increases as interest rates rise, mitigating the negative effect of higher rates.

The outlook for the asset class is good. "After a quieter August, analysts expect a healthy issuance calendar to materialise in both Europe and the US," says Maxime Perrin, product specialist at Lombard Odier Investment Managers. "Looking at the months ahead and beyond, we expect the multiple sources of returns provided by convertible bonds – income, risk-controlled equity exposure, and valuation improvements – to continue being very attractive."

Portfolio uses

Convertible bond funds may be attractive to investors who don't want the risk of investing in equities but are looking to earn more than they currently do from cash and gilts, and are willing to take a bit of extra risk, according to Mr Lowcock.

Some argue that if you are going to take on a little more risk than mainstream bonds then it is worth looking at large-cap equity income shares, which are typically reliable dividend payers and less volatile than cyclical shares. However Mr Vallee argues that these companies can still cancel their dividends in times of trouble, whereas a bond coupon payment is fixed. Conversely, equities can increase their dividends protecting against interest rate rises.

The convertibles market is relatively small, quite esoteric and not generally made up of high quality companies so this type of fund should make up less than 5 per cent of a portfolio, according to Algernon Percy, multi-asset manager at JOHIM. "I am comfortable including these to a modest degree in some private client portfolios – particularly those who lack exposure to alternatives and need income," he adds.

Funds

Private investors in the UK do not have a wide choice of convertible bond funds. But this year an investment trust targeting this asset class launched. JPMorgan Global Convertibles Income Fund (JGCI) is targeting a yield of 4.5 per cent in its first year, and 6 to 7 per cent thereafter. It will achieve this by targeting higher yielding mid and small-cap or less liquid issues than some open-ended funds do.

"JPMorgan Global Convertibles Income Fund may appeal to investors looking to further diversify their sources of income within a portfolio, albeit is likely to have a large exposure to higher-yielding, lower credit quality and smaller size of underlying issuers in order to generate the target yield," comments broker Killik. "The portfolio is therefore likely to exhibit greater risk characteristics and higher volatility."

The trust also trades at a premium to its net asset value of more than 5 per cent. "The premium looks challenging but compared to other income areas it is not abnormal, though I would prefer a better entry point," says Ben Gutteridge, fund analyst at Brewin Dolphin.

There is only one open-ended onshore domiciled option, M&G Global Convertibles Fund (GB00B1Z68270).

"M&G fund managers have a well established reputation as bond managers," says Mr Lowcock. "M&G Global Convertibles Fund currently yields 2.09 per cent and was established in 2007 in anticipation of growing demand and supply of these types of bonds."

Other than these funds, investors need to consider offshore options. Before you invest in an offshore fund you need to ensure that it has UK reporting status, or you may incur income tax rather than capital gains tax when you sell it. You also need to check that it qualifies for the tax benefits of Isas and Sipps, and watch the charges, because offshore funds can be more expensive.

A strong performer over three and five years with UK reporting status is RWC Global Convertibles Fund (LU0280814137), though this requires a minimum investment of £25,000. However, if you buy it off a platform such as Hargreaves Lansdown you can invest a minimum of £500, and you should also be able to invest smaller amounts if you buy it via an adviser.

F&C Global Convertible Bond Fund (LU0417633616) has UK reporting status and a Sterling share class. It is among the top ten best performing offshore convertible bond funds over three and five years. It is available on platforms such as Hargreaves Lansdown and Selftrade, or via an adviser.

Mr Gilligan suggests Salar Fund of which the C1 share class (IE00B2PLHP55) has UK reporting status."The fund, managed by convertible bond specialists Ferox Capital, aims to generate capital growth, whilst seeking to preserve capital, through a variety of strategies generally in the convertible bond markets," says Mr Gilligan. "The managers offer a balanced investment strategy, taking a cautious approach to balancing the sensitivity of a bond's price to a price change in the underlying equity with the credit quality within the portfolio in order to achieve an attractive total return of capital growth and income yield."

The fund is top quartile in its offshore sector over one year. However, to purchase this fund you need to go via an adviser.

Suggested convertible bond funds

Source: Morningstar as at 31 August 2013, *Killik & Co