Much has changed in recent days about the prospects for aggressive rate cuts by the Fed. It seems the economic data that is tied mostly to the consumer is faring pretty well in terms of jobs, retail sales, household wealth gains and general optimism, some of which is a byproduct of the election results. As of Nov. 8, there is a 65% probability of the Fed lowering the fed funds rate by another quarter-point at the Dec. 18 Federal Open Market Committee (FOMC) meeting. This figure is down from 82.7% a week ago, with the probability of the Fed keeping rates unchanged at 35%, and up from 17% a week ago.
Going out to the Jan. 29 FOMC meeting, the odds of a rate cut are only 54%, and it isn’t until the March timeframe that the bond futures market thinks a move to the 4.00-4.25% range will occur, assuming the economy doesn’t reaccelerate under the new pro-business Trump administration. The case for rates remaining unchanged indefinitely is building slowly and will obviously be data dependent on whether this is just a temporary thought process running its course, or something more credible.
What the majority of Wall Street chief market analysts do believe is that the equity market is on good footing and poised to add into 2025, but not to the extent of the big gains realized in 2024. Most of the big brokers are forecasting 10%+ gains for the S&P for next year. For income investors, this trend cuts both ways. On the one hand, if rates remain where they are, the potential for capital appreciation for fixed income assets from a bond rally is greatly diminished. On the other hand, yields remain at current levels, allowing one to roll over short-term maturities at existing yields.
However, there is a way income investors can have their cake and eat it too in a market where bonds trade flat and stocks rally. They can invest in convertible debt instruments, be they convertible bonds or convertible preferred stocks. As a refresher, convertible bonds and convertible preferred stocks are a type of corporate debt security that offers investors the option to convert the bond or preferred into a predetermined number of the company’s underlying common stock shares.
There are a few key points about convertible debt. Like regular bonds, convertibles pay periodic interest to the holders of convertible debt instruments. The conversion from the bond to stock happens at specific times during the convertible’s life and is usually at the discretion of the owner of the convertible. A convertible bond or preferred offers investors a type of hybrid security that has features of a bond, such as interest payments, while also having the option to own the underlying stock.
Every convertible bond or convertible preferred has a “conversion ratio” that determines how many shares of stock the bondholder or preferred holder will receive upon conversion. For example, a 5:1 ratio means one convertible bond or one share of convertible preferred stock converts into five shares of common stock at a specified “conversion price.” The conversion price is the price per share at which a convertible security can be converted into common stock. This price is set at the same time as when the conversion ratio is decided by a convertible security.
Convertible bond and convertible preferred debt allow investors to lock in bond yields and participate in the potential for the common stock to appreciate, being they are “tied” to the common stock. When an underlying common stock rallies higher, so too do the corresponding convertible securities. It is a way to get paid well while waiting for the underlying stock to make a move higher, at which time the holder of convertible debt may elect to convert the debt instrument into common stock shares if the stock is trading at or above the conversion price.
The one other consideration is that convertible bonds and preferreds typically offer lower interest rates compared to regular bonds because of the added potential for equity participation through conversion. Convertible debt is thereby a bull market offensive strategy, whereas investing in regular bonds is a considerably more defensive strategy. Convertibles are an excellent rebalancing tool for income investors overweighted in debt securities that desire equity market expose without sacrificing much in the way of overall portfolio yield.
As a sector, convertible debt has gained roughly 10% in 2024, not including yield, which reflects the correlation to the stock market, whereas Treasuries along the spectrum of the yield curve have relinquished most of their 2024 gains with the recent selling pressure pushing regular bond prices lower.
Because many convertibles trade in secondary markets and are more difficult to find and invest in, buying into convertible debt ETFs and convertible debt closed-end funds is the easiest way to gain exposure and diversification to the sector. Here are some examples of both:
American Century Quality Convertible Securities ETF (QCON) — Yield 2.27%
iShares Convertible Bond ETF (ICVT) — Yield 2.27%
Bancroft Fund (BCV) — Yield 7.10% (20% leveraged)
Calamos Convertible Opportunities & Income Fund (CHI) — Yield 9.60% (36% leveraged)
