US convertible bonds feel equities’ pain

US convertible bonds are suffering their worst monthly performance since the height of the Greek debt crisis last year.

As equity markets have tumbled in the face of weaker economic data and amid Europe’s sovereign debt woes, convertible bond prices have fallen 3.1 per cent so far in June, putting them on track for their worst month since May 2010, according to figures tracked by Bank of America Merrill Lynch.

Before a rally this week, the convertibles index, which excludes mandatory convertibles, was matching its worst monthly decline since late 2008.

“As an equity-linked product, convertibles can feel the effect of a softening equity market,” said Prasanth Burri Rao-Kathi, head of Americas equity-linked capital markets at BofA Merrill Lynch.

The hybrid securities, sold as bonds paying a yield but which can be converted into equities, are typically sold by riskier, fast-growing companies.

Last year, bond funds including Pimco began pouring money into convertibles. They aimed to capture some of the stock market’s rally via convertibles’ equity component as the economy improved.

Prices of convertibles reached their highest since at least the late 1980s in April, according to the BofA Merrill Lynch index, a return of more than 90 per cent since their post-crisis bottom in November 2008. But the stumbling economy has led to a paring of positions in recent weeks.

“Valuations have been taken to unsustainable levels, and we’ve begun to see the inevitable reckoning,” said David Puritz, global co-head of convertibles at Nomura.

According to Morningstar, convertible mutual funds are down 2.8 per cent in the past month, though they are still up 2.4 per cent so far this year.

In particular, funds that had used derivatives to focus on moves in the equity component of convertible bonds have seen lower returns as corporate “spreads”, or premiums over benchmark Treasury bonds, have increased.

“To the degree accounts have hedged their rate exposure, convertible portfolios have massively underperformed the move in Treasuries,” said Mr Puritz.

But, unlike in past convertible price corrections, leveraged hedge funds represent a smaller portion of the market. Traders say there is little risk of the indiscriminate selling that led to monthly declines of nearly 20 per cent in 2008.

“This volatility creates opportunity,” said Tracy Maitland, president of Advent Capital Management. “It sets up a better second half for investors than where we were at the end of April.”