Convertibles as an Asset Class - 2002 Update

By Goldman Sachs Global Convertible Research (Scott Lange, Dan Sommers, Rashmi Jolly, et al.); February 19, 2003

A paper by Goldman Sachs summarizes Ibbotson Associates ' study and comes to the conclusion: Convertibles remain compelling in delivering returns that approach those of equities with much less volatility.

Conclusions

• Attractive long-term risk/reward profile

Ibbotson’s long-term analysis of convertible-market performance - now updated through 2002 - shows returns for this asset class that nearly equal those of equities, but with substantially lower volatility.

• Convertibles’ risk/reward profile relative to equities remains compelling

Since 1973, the US convertible asset class has delivered 70% upside participation with the S&P; 500 when stocks were rising, and only 53% downside participation when stocks were falling. This 70%/53% upside/downside for the long-term data series is slightly improved from 2001’s readings owing to the defensive characteristics of convertibles during last year’s continued equity-market declines.

• Drivers for continued strong relative performance remain in place

Convertibles typically appear underpriced at issue, and the unwinding of this undervaluation should continue to serve as a driver of strong long-term performance for the asset class. Inefficient callability, where issuers rarely call their convertibles at the optimum moment, further enhances long-run performance relative to theoretical expectations. From a shorter-term perspective, however, the current 'busted' state of the market (i.e., far out-of-the-money embedded optionality) could constrain convertibles’ relative upside performance if equities were to experience an unusually strong recovery; relative performance with more typical upside equity returns should remain attractive, in our opinion.

• New convertible issuance slowed significantly in 2002 from prior trends

A continued sell-off in US stocks in 2002 dampened the appeal of issuing equity or equity-linked securities. The resulting lack of supply led to US convertible issuance of $56 billion in 2002, down substantially from 2001’s record $104 billion. Early indications for 2003 point to healthier conditions for convertible financings, which should support a solid new-issue calendar in coming months.

• Convertibles are particularly useful in optimizing fixed-income portfolios

Convertibles’ long-term performance has been highly correlated with large- and small-cap stocks, but much less correlated with the various fixed-income asset classes. This implies that convertibles will provide particularly effective diversification in fixed-income-oriented portfolios.

Compelling long-term convertible performance

We summarize below some of our findings based on the extensive research conducted by Ibbotson Associates in association with Goldman Sachs over the past several years:

• Over the period for which reliable long-run data are available (i.e., since the early 1970s), the total return performance of the US convertible market has nearly equaled that of the S&P; 500, but with substantially lower volatility. Over this period, convertibles have outperformed long-term corporate bonds, but with modestly higher volatility.
• The total returns for convertible bonds have demonstrated a much higher correlation with the S&P; 500 than with the corporate bond universe.
• Convertibles are useful in optimizing performance in both fixed-income and equityportfolios.

Sustainable rationale for outperformance

We highlight three possible reasons for this apparent long-run outperformance of convertible instruments:

• Typically attractive convertible pricing at issue.
• Ostensibly inefficient company timing in calling convertible instruments.
• Exposure to a universe of higher-beta underlying stocks (than the S&P; 500) through a period of long-run excess returns from equities.

We believe that the first two reasons in particular are sustainable going forward, with positive implications for the future performance of the convertible asset class. From a shorter-term perspective, however, the current 'busted' state of the market (i.e., far out-of-the-money embedded optionality) could constrain convertibles’ relative upside performance if equities were to experience an unusually strong recovery; relative performance with more typical upside equity returns should remain attractive, in our opinion.

See also

• Convertible Bonds as an Asset Class: 1957-1992
• Convertibles as an Asset Class - 2000 Update (Global)
• Convertibles as an Asset Class - 2001 Update (Global)