Investors looking to protect against downside risk while still taking advantage of an equity bull market could use convertible bonds as equity and fixed income substitutes, according to consulting firm Rocaton.

Convertibles—bonds that switches to equities according to the agreed terms of the security—could provide an attractive asymmetrical return profile, the consulting firm said, by “meaningful upside participation in rising equity markets and less downside participation in falling markets.” 

“Convertibles can play a role in most portfolios given their ability to participate in equity market rallies and limit downside outcomes,” Rocaton’s report said.

According to Rocaton’s data, convertibles have outperformed US equities by 62 basis points annually with 16% less volatility over the past eight years. The current yield for the convertible bond index is also higher than both bonds and stocks, the paper said, at 2.6% compared to 2.4% for the Barclays Aggregate and 1.9% dividend yield for S&P 500.

Investors should use active management to gain exposure to convertibles, the paper said.

“Generally speaking, passive unmanaged exposures to convertibles likely will not achieve this return profile as higher equity sensitive positions ideally should be exited in favor of less equity sensitive positions as equity markets rise, and in falling markets, less equity sensitive positions should be sold in favor of greater equity sensitivity names,” Rocaton said.

Such rebalancing, or total return, strategy could act as an equity substitute in a diversified portfolio, according to the report, capturing asymmetric return characteristics by catching the upside of the underlying stock while limiting the downside.

For investors looking to replace high yield or below investment grade fixed income, busted convertibles—with little equity sensitivity—could provide them with modest yield, the paper said, while maintaining their link to equity.

“Busted bonds are typically overlooked by total return investors and convertible arbitrageurs, who together control most of the convertibles market,” the consulting firm said. “As a result, they are subject to occasional periodic mispricing and dislocations, creating opportunities for active management.”

Investors should be aware of convertibles’ apparent risks, however, Rocaton argued. Its smaller and relatively illiquid market—approximately $350 billion in total market value globally—could cause periods of “higher than normal volatility due to liquidity shocks,” the paper said.

However, the report argued the pros of allocating to convertibles outweigh the cons. “Regardless of the investor type or the specific strategy, convertibles can play a role in most portfolios given their ability to participate in equity market rallies and limit downside outcomes,” it said.

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