In today’s market environment, uncertainty is widespread. Equity valuations are extended in some regions, following the longest bull run in history, while credit spreads are close to decade lows, as investors’ hunt for yield has led them to riskier areas of the fixed income market, notably against a backdrop of historically low risk-free rates. With equity, credit and interest rate markets stretched, downside risks significantly outweigh upside potential. 
How should investors prepare for the unexpected or the possibility of the improbable?
For investors seeking to protect their portfolios against these downside risks without having to forgo gains to the upside, hedged convertible bonds present an attractive solution.
The hybrid nature of convertible securities where the holder can convert the bond into common shares of the underlying company at a predetermined price provides fixed income investors with the ability to monetise market volatility as an additional source of returns, while also hedging credit risk with the equity underlying the convertible. As such, hedged convertibles can offer greater return potential than the high-yield marketplace, but with approximately half the risk.
Within hedged convertibles strategies, specifically convertible arbitrage strategies, a long convertible bond position is paired with a short stock position in the same company. In rising markets, the long convertible bond position, because of its asymmetric return profile, will typically make more than the short stock position loses, generating positive profit & loss. In falling markets, the long convertible bond position, again because of its asymmetric return profile, will typically lose less than the short stock position makes, also generating positive profit & loss. As such, hedged convertibles can offer investors the ability to generate returns in both up and down markets, in addition to monetising periods of sustained market volatility. This source of returns, also known as volatility yield, supplements the traditional drivers of return to fixed income investments - namely coupon and accretion - and can allow for greater return potential versus traditional fixed income securities.
While the potential for return generation via hedged convertibles is, alone, quite compelling, what is particularly relevant are the risks taken in order to achieve this return potential. In the case of convertible arbitrage strategies, position-level hedges - specifically, the short stock position paired against the long convertible bond position of the same company - not only serves as a source of returns, but also to reduce chances of capital impairment.
Said differently, for every $1 invested in traditional fixed income securities, investors have one dollar of risk. Conversely, for every $1 of exposure invested in hedged convertibles, approximately half the risk is hedged with a corresponding, short stock position in the same company. This position-level hedge is, broadly speaking, the most effective hedge to the credit risk taken via the long convertible bond. The ability to hedge credit risk with a short stock position in the equity of the same company means that not only can hedged convertibles offer greater return potential, compared to high-yield issuers of a similar nature through the monetisation of market volatility, but that investors can do so with approximately half the credit risk.
In addition to reducing credit risk, hedged convertibles have the ability to reduce duration risk, and as such, provide superior protection from rising interest rates. The average duration of the convertible securities asset class is approximately two years. This can be compared to an average duration in the high-yield marketplace of approximately four and a half years and an average duration in the investment grade marketplace of approximately seven years.
Convertible securities have also typically outperformed traditional fixed income investments, including high yield securities, in periods of rising interest rates. At their onset, rising interest rate environments are most often accompanied by increased market volatility, which benefits a convertible bond’s valuation through the increased value of the conversion option, similar to a call or put option during periods of rising uncertainty. Rising interest rate environments are typified by supportive equity market backdrops, which also benefit convertible bonds given convertibles’ ability to participate in equity upside.
With growing concerns of complacency over the risk of inflation, hedged convertibles not only provide greater return potential, as compared to the high-yield marketplace, but with approximately half the credit risk and half the duration risk.
Sarah George is vice president and client portfolio manager at Lazard Asset Management. The views expressed above are her own and should not be taken as investment advice.