Convertibles – A Superior Fixed Income Alternative in a Rising Rate Environment

Yields on longer-dated treasury bonds rose sharply over the past year, igniting investor concerns about the impact of rising rates on fixed income returns. The absolute level of yield on the 10-year treasury has historically been the best predictor of 10-year forward returns on fixed income, which makes it difficult for allocators to meet their return goals. In the short run, the path for rates seems headed higher fueled by vaccination driven reopening, and monetary and fiscal stimulus. This is happening at a time when credit spreads in high yield securities have compressed to record lows, while investors chase yield and illiquid assets, amidst a highly stimulatory monetary policy and a sea of liquidity.

Given the still low levels of yields and spreads, near term fixed income return distribution is likely to be more skewed to the downside, more so in the treasury complex, but also to some extent in high yield, as there is very little room for spread compression to offset rising yields. This challenges the role of fixed income as a diversifier to equities in asset allocation. Given that the outlook for absolute returns from fixed income over the next decade is challenging, investors need to explore alternative solutions in order to reach return targets, while mitigating multiple risk components.

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