The Road Ahead for the Convertible Bond Market

In Brief

Convertible bonds’ delta (sensitivity to changes in underlying equity prices) was at low levels at the start of 2024, a condition which historically has been favorable for forward returns.
Also significant for the market in 2024: Higher interest rates may help boost issuance of convertible securities as issuers look to reduce borrowing costs; and new issuance may come from a more diversified mix of companies.
Finally, continued stock-market strength in 2024 may help convertible bonds to capture an increasing proportion of any prospective equity upside.

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The U.S. convertible bond market faced challenges in 2023 as the lower-delta nature of the market and a lack of exposure to mega-cap technology stocks constrained returns relative to broader equity indexes, as shown in Figure 1. (Delta is a measure of bond price sensitivity to moves in the underlying equities.) Additionally, given the asset class’s skew toward growth, innovation, and early-cycle, smaller-capitalization companies, concerns about slowing U.S. economic growth and rapidly rising interest rates added an additional headwind, leading to outflows in convertible-bond mutual funds in 2023 (based on (based on fund-flow data from Lipper through December 20, 2023).

Figure 1. Convertible Bonds Trailed Equity Benchmarks in 2023, But Showed Late-Year Strength

Year-to-date (through December 26, 2023) total return for indicated indexes

Source: Bloomberg, ICE BofA Indices. ICE BofA All U.S. Convertible = ICE BofA U.S. Convertible Index. S&P 500 = S&P 500^® Index. Nasdaq Composite = Nasdaq Composite Index. Russell 2000 Growth = Russell 2000^® Growth Index.

For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

Past performance is not a reliable indicator or guarantee of future results.

However, the move lower in U.S. Treasury yields since late October, sustained by the U.S. Federal Reserve’s (Fed) dovish policy pivot in December, resulted in a sharp recovery, with the ICE BofA U.S. Convertibles Index climbing nearly 10% in the last two months of the year (through December 26), accounting for the majority of 2023’s total return.

We believe convertibles are poised for a continued strong rebound in 2024. Why? First, the convertible market delta has been range-bound in the mid-40s and remains near the post-global financial crisis lows. This is noteworthy, as forward returns have historically been favorable when market delta is at these lower levels. Furthermore, given that nearly half of the market is considered “bond-like” (delta below 0.40), based on data from ICE BofA Indices, we believe the asset class’s lower equity sensitivity may appeal to investors who are concerned about the potential for a pullback in the stock market.

Second, because of the Fed’s aggressive rate hiking cycle, new issuance has once again begun to pick up as an alternative to the higher borrowing costs associated with “straight” (non-convertible) debt, based on data from Dealogic. We have also seen rising diversification, with a large portion of new issuance coming from less traditional convertible-bond sectors, such as Utilities, Financials, and Communication Services. Should we remain in a “higher-for-longer” interest-rate environment, we believe convertibles should benefit as the refinancing trend continues among both existing convertible bond issuers, as well as crossover issuers from the high yield and investment-grade universe. This diversification should provide a more balanced set of exposures going forward, in our view.

Lastly, while narrow technology-focused market leadership was the dominant theme for most of 2023, market breadth meaningfully improved throughout November and December amid encouraging inflation data and the increased prospect for a “soft landing” for the U.S. economy. Should this trend continue, and the underlying equities of convertible issuers continue to rally, their bonds’ embedded conversion options will move closer to being “in-the-money” (i.e., their conversion price is less than the share price of the underlying equity)—enabling convertible bonds to capture an increasing proportion of any prospective equity upside.

Even with the rate relief of late, we do see credit stress remaining in a number of early-cycle issuers who have not been able to transition to profitability in a higher-rate environment. This leaves us cautious on truly “busted” convertibles. Instead, we see opportunity in a growing number of liability management exercises in the year ahead, as issuers tackle maturity walls and potentially benefit from takeouts in strategic merger and acquisition (M&A) activity.

Our in-house credit and equity analysis expertise keeps us focused on the lower-delta, credit-sensitive segment of the market (sub-40% delta), as well as the equity-sensitive (greater than 80% delta) segments where we see prospects for broadening equity market participation as a tailwind.

LACFX

Class A

Convertible Fund

The Lord Abbett Convertible Fund seeks to deliver current income and the opportunity for capital appreciation by investing in convertible securities.

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LAGWX

Class A

Developing Growth Fund

The Lord Abbett Developing Growth Fund seeks to deliver long-term growth of capital by investing primarily in stocks of small U.S. companies. Learn more.

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About the Author

Robert Sanchez

Product Specialist

Robert Sanchez is a Product Specialist responsible for covering Lord Abbett’s U.S. Equity strategies. In this role, he is responsible for developing investment narratives, marketing materials, and strategic plans for our products across retail and institutional channels.

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Glossary & Index Definitions

Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes.

A busted convertible bond refers to one whose underlying stock trades far below its conversion price, causing it to act like a straight bond given that there is a very low probability that it will ever reach the convertible price before maturity.

Delta represents the sensitivity of the price of a convertible bond to changes in the price of the underlying stock.

Growth/Value Investing: Growth stocks may be characterized as equities of companies that have demonstrated better-than-average gains in earnings in recent years and that are expected to continue delivering high levels of profit growth. Growth equities typically carry higher price-to-earnings multiples than the broader market, high earnings growth records, and greater volatility than broader market. Secular growth stocks are stocks of companies whose economic performance is relatively immune to economic cycles. Value stocks may be characterized as equities of companies that have fallen out of favor with investors but still have good fundamentals, or new companies that have yet to be recognized by investors. Value stocks typically feature lower price-to-earnings multiples than the broader market, and often industry peers; and somewhat lower volatility than the overall equity market.

Hawkish/dovish monetary policy: “Hawk” is a term for policymakers and advisors who favor higher interest rates to keep inflation in check. “Doves” prefers an interest rate policy that is more accommodative in order to stimulate spending in an economy.

Maturity wall refers to a large amount of debt coming due in the bond market in a narrow time frame.

The yield on a security is the amount of cash (in percentage terms) that returns to the owners of the security, in the form of interest or dividends received from it.

The ICE BofA U.S. Convertible Index tracks the performance of publicly issued U.S. dollar-denominated convertible securities of U.S. companies.

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