- Investors seeking high yield may consider reverse convertibles with massive coupons in return for significant downside risk. These investors may also consider the corporate-bond market.
- To examine if reverse convertibles offered risk-return benefits over high-yield bonds, we rolled over all one-year historical stress scenarios since 2006 and calculated the total return of hypothetical reverse-convertible and high-yield bond portfolios.
- Our investigation shows some specific market conditions favored reverse convertibles, but harvesting the excess return would have required foresight and a high risk tolerance.
Despite drawing regulatory scrutiny,1 reverse convertible notes represent about 50% of the institutional structured-product market.2 The coupons paid by these instruments may be hefty, but they can leave investors exposed to the large downside risk of the underlying security or basket.3 Investors seeking high yield may also turn to the corporate-bond market, so one may wonder whether reverse convertibles offer any obvious risk-return benefits over traditional high-yield bonds. Our investigation based on historical scenarios shows that some specific market conditions favored reverse convertibles, but that harvesting their excess return would have required foresight and a high tolerance for risk.4
In our analysis, we compare the performance of a hypothetical portfolio of 5-year high-yield bonds5 to that of a hypothetical portfolio of 1-year reverse convertible notes on the equities of the same bond issuers,6 over a one-year horizon. In addition, we make the following assumptions:
- The bond portfolio is marked to market at the end of the one-year horizon.
- Reverse convertibles are held until maturity.
- Reverse-convertible issuers do not default.
We rolled over all one-year historical stress scenarios between Nov, 2006 and Jun, 2019 (about 3,000 scenarios)7; and for each one, we calculated the total return of the two portfolios (including coupon payments, price return and redemptions).8 The difference between the total return of the reverse-convertible portfolio and that of the bond portfolio is the excess return we are measuring.
Reverse convertibles’ excess returns simulated over historical stress scenarios
Source: MSCI; IHS Markit. The heat map represents reverse convertibles’ excess return for different historical stress scenarios. Blue dots represent scenarios where reverse convertibles outperformed high-yield bonds. The percentages in the boxes indicate the portion of scenarios falling into each of the quadrants.
The excess return is shown on the exhibit above as a function of the historical performance of the U.S. equity market (represented by the return of the MSCI USA Index) and that of the U.S. high-yield bond market (measured by the return of the iBoxx USD Liquid High Yield Index ).
Examining the historical stress scenarios, we can see a pattern emerge. Reverse convertibles tended to outperform high-yield bonds in scenarios with rising (or flat) equity prices accompanied by increasing bond yields, but the excess return remained under 7% for all scenarios. On the other hand, high-yield bonds outperformed reverse convertibles in the majority of stress scenarios, typically when stock prices and yields moved in opposite directions: e.g., during the 2008 financial crisis and recovery. In particular, historical scenarios in which stock prices and yields both rose tended to favor high-yield bonds, due to the limited return potential of reverse convertibles.
The exhibit also shows that excess returns extended deeply into the negative range, suggesting a heavily skewed distribution. Comparing the empirical return distribution of the two portfolios on the below historgram helps to explain this skewness. Even though reverse convertibles showed a higher loss potential than high-yield bonds, their return potential was conspicuously lower due to its capped nature. Factors that mitigate high-yield-bond risk (compared to reverse convertibles) include recovery on default (which limits the potential loss) and the fact that equity prices can plummet even if there is no significant increase in default probability.
Scaled histograms of high-yield bond and reverse convertible returns
Source: MSCI; IHS Markit.
To summarize, our analysis suggests that reverse convertibles may have offered excess returns over high-yield bonds when stock markets were bullish and bond markets were bearish as illustrated in our investigation. At the same time, reverse convertibles’ limited upside potential is overshadowed by a disproportionately large downside risk, which penalized returns when market conditions became unfavorable.
The authors thank Aniko Maraz for her assistance to this blog post.
1 See, for instance: “Reverse Convertibles — Complex Investment Vehicles.” Financial Industry Regulatory Authority
2 The data provider Structuredretailproducts.com estimates that the 2018 institutional structured-product sales volume was USD 20 billion.
3 Reverse convertibles are a combination of a long-bond position and a short put derived from an equity, basket of equities or equity index. The option premium is paid out to the investor in the form of a bond coupon.
4 This report may contain analysis of historical data, which may include hypothetical, backtested or simulated performance results. There are frequently material differences between backtested or simulated performance results and actual results subsequently achieved by any investment strategy. The analysis and observations in this report are limited solely to the period of the relevant historical data, backtest or simulation. Past performance — whether actual, backtested or simulated — is no indication or guarantee of future performance. None of the information or analysis herein is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision or asset allocation and should not be relied on as such.
5 The hypothetical bond portfolio contained 189 U.S.-denominated corporate bonds from issuers below investment grade (but not in default).
6 The strike of the reverse convertibles was set to 80% of the initial equity price, and their coupons correspond to the option premiums backed out from the implied volatility of the underlying equities.
7 We used MSCI’s RiskMetrics® RiskManager® to run the historical stress scenarios on the bond and reverse-convertible portfolio.
8 Bond returns under stress scenarios were computed by pricing hypothetical fixed-rate bonds using the relevant stressed issuer’s yield curves.
Investing in convertible bonds when rates rise