Bond strategy: may the odds be ever in your favor
Targeting convertible bonds and defaulted securities to goose return
Summertime in the investing business is a season of calm. The frenzied schedule of meetings and quick-turnaround research gives way to floating carelessly in lakes and pools. The interns have arrived to man the ramparts of the Bloomberg terminal on the lookout for sudden turns of fortune. And so, in a state of decidedly reduced tension, the mind can focus on more enduring issues. This is a time to think.
One of the areas for pondering in fixed income is which asset classes within the group deliver a higher average return. Does every type of bond end up with a similar return over time or are some classes better than others? To answer this question, for the U.S. dollar credit markets at least, we turn to our friends at CreditSights whose record-keeping on these matters is of a high standard.
For the decade ending May 2021, the hands down winner amongst fixed-income categories was…convertible bonds, which returned an astonishing 13.9%, annualized, for the period between 2011 and 2021. While not every convert went into the money, evidently enough of them did to vastly outpace the other fixed income categories1.
Now from the back of the room we hear someone calling out the classic heckle of return comparisons…“Ending point bias!” And it is true that the last year especially has been very good for stocks, and some convertible bonds have been pulled along on the ride. But if we were to move the period end to a less favourable spot on the equity market calendar, say December 2016 or December 2018, the results for this class still best the other classes of credit. For instance, the 10 years ending May 2016 (a period including the Great Financial Crisis) saw U.S. convertible bonds return 7.6% annualized2, still a faster clip than other bonds or loans.
Another high returning category, according to the averages, is bonds that have defaulted. For the period encompassing the 29 years between 1987 and 2016, Professor Ed Altman, in his exhaustive study done in cooperation with the NYU Salomon Center, calculates the return from defaulted bonds as 13.6% annualized3, during the first 24 months from the point of default. Subsequent to important changes in the US bankruptcy code in 2006, which served to speed corporate reorganizations, the rate of returns on defaulted bonds has increased. Between 2006 and 2016, defaulted bonds in the first 24 months following default grew in value at an annual rate of 19.9%3.
With such strong returns in both convertible bonds and defaulted securities why, you might ask, do so few fixed-income mandates include such securities? We ask ourselves the same question. Volatility is sometimes offered as a reason. But when you look at the statistical volatility of a mandate like the Pender Corporate Bond Fund and compare it to, say, the volatility of mandates focused on long duration government bonds, taking the iShares 20+ Year Treasury Bond ETF as an example, one actually observes lower volatility in recent five-year periods4.
We believe that the more likely explanation is that including convertibles and defaulted securities just amounts to too much work for the big passive or near-passive strategies that dominate the fixed-income category. There are no ratings to hang your hat on, so investors need to do their own evaluations of these entities. Especially with distressed securities, where there is a lot of process involved. A distressed credit investor needs to read filings, vote their proxies, and sometimes negotiate with the issuer or other investors.
Of course, past performance, as any good lawyer will tell you, is no indication of future results. And we ourselves do not invest blindly in these areas without considerable due diligence on our particular investments. But, like Katniss Everdeen, the heroine of The Hunger Games books and movies, we live in the hope that the odds may be ever in our favour.
1. CreditSights, May 28, 2021.
2. CreditSights, December 2016.
3. Altman/Hotchkins, Corporate Financial Distress, Restructuring and Bankruptcy, 4th edition, Wiley, 2019 see pp 289-291.
4. Morningstar (5-yr standard deviation as of June 30, 2021).
Geoff Castle is Portfolio Manager of the Pender Corporate Bond Fund at PenderFund Capital Management. Excerpted from the Pender Fixed Income – Manager’s Commentary – June 2021. Used with permission.
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