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Convertibles: Rewards with higher risk

Convertible bond funds can offer steady income and as well as equity participation, but at the expense of volatility and exposure to low credit quality.

Recent research indicates that private investors have retained a preference for income. However, the rally in equity markets since the start of the year might be too tempting to ignore.

FE Advisory’s most viewed funds in Hong Kong and Singapore in 2018 were income-generating products, including high yield and dividend-focused funds. The trend continued in January, according to figures from Fund Info, whose clients include fund distributors such as private banks, retail banks and wealth managers.

Yet, they might risk missing opportunities for capital growth if they avoid participating in surging equities markets. Convertible bond funds might be an attractive middle way.

A convertible bond is a type of interest-paying debt security that can be turned into a set amount of the underlying company’s equity according to a specified formula, usually at the discretion of the bondholder. It is a hybrid, paying a fixed coupon like a bond, but through the convertibility option, allowing the investor to participate in the potential capital appreciation of the equity.

The flip side is that the interest payment is normally less  – a third to a half smaller – than the coupon paid by a vanilla bond issued by the same borrower, and that the investor has to pay a conversion premium to switch into the company’s shares.

Convertible bond holders also rank behind other debt holders for payment if the company goes into liquidation.

Among the seven funds accessible to Hong Kong and Singapore retail investors, the $437.3m Franklin Global Convertible Securities Fund has the best three-year cumulative performance, earning a 46.26% return, followed next by the AXA World Funds Framlington Global Convertibles Fund (19.57%) and the JGF-Jupiter Global Convertibles I HSS Fund (17.8%) in third place.

However, investors need strong stomachs to cope with the the volatility intrinsic to the sector and have phlegmatic temperaments to tolerate funds with large exposure to unrated credits.

The annualised volatility of the Franklin fund is 9.13%, much higher than 3.91% average volatility for the fixed income fund sector and only a little less than the 10.6% volatility of the equity fund sectors. As much as 70% of convertible bonds held by the Franklin fund have no rating.

Convertible fund sector vs equity and fixed income fund sectors

Source: FE Analytics. Three-year cumulative returns in US dollars.

Part of the Bonhill Group.