The AI craze is supercharging returns in yet another sleepy corner of financial markets-this time, convertible bonds. It could mean a new set of risks for investors.
Convertibles are a hybrid between stocks and bonds. They offer steady bondlike payouts but typically also promise investors an option to convert the security into a stock if the issuer's share price climbs high enough.
With outstanding issuance just under $500 billion, convertibles represent a relatively small corner of the bond market. But they are getting a lot of attention thanks to a combination of stock market beating returns and a wave of issuance by tech firms this year, including neo-cloud companies CoreWeave and Nebius and hyperscalers Alphabet and Oracle. (The latter two issued mandatory convertibles, a variation on the product.)
All in all, issuers sold nearly than $90 billion in convertible bonds in the second quarter, according to data firm Dealogic, up 80% from a year ago and the strongest quarter on record.
For investors, convertibles offer the downside protection of a bond, such as the promise to get principal back, without sacrificing potential upside if stock prices rocket higher. Convertible bonds typically include an option to convert to stock if the issuer's share prices climb 20% to 30%.
Borrowers, including tech companies, favor them because they allow issuers to lock in interest rates that compare favorably to traditional bonds. The average yield on Barclays Convertible Composite index was just 2.1%, according to a recent report from the firm.
The AI gold rush has transformed the space, with roughly 30% of global convertible bonds now tied to AI, according to a recent note from BofA Global Research. AI's lopsided presence in the market provides big opportunities-and risks for investors, just as AI has transformed the risk/reward profile of other markets such as utilities and South Korean stocks.
The market's leading convertible mutual and exchange-traded funds are having a great year. The index-tracking iShares Convertible Bond ETF has returned 22%. Fidelity Convertible Securities Fund, which is actively managed, has returned 20%. The S&P 500, by contrast, is up just 14%.
But those big numbers should give investors who think of convertibles as risk-off investment some pause. Thanks to the eruption of AI-related convertible issuance the iShares fund has more than 44% of its holdings invested in technology, with extra-volatile names such as Western Digital, Alibaba Group, and Lumentum Holdings as its top three holdings.
Meanwhile, the iShares fund's yield is just 1.4%, indicating that this year's gains are mainly tied to convertible bonds' price appreciation, rather than interest income, a key attraction of standard bonds. It also suggests investors will have relatively little income to act as a cushion against losses if prices head south.
Still, BofA Securities analyst Michael Youngworth wrote in a note last week that convertibles represent a unique opportunity, and that given AI's long-term potential investors can't afford to sit out the trade.
"However, the timing and path risk pose challenges given the trade's high vol[atility], propensity for sharp pullbacks, and uncertainty over which names will ultimately prevail. Convertible bonds allow investors to participate in AI equities with long-dated optionality, making the timing less critical and the drawdowns less severe," he wrote.
A reasonable point, but it is worth parsing the subtleties.
Youngworth is noting convertible bonds offer a less-risky way to bet on AI than owning AI stocks directly. What he isn't saying is that convertible bonds provide a less risky alternative to a diversified stock portfolio, much less a portfolio that includes stocks and bonds.
The Calamos Convertible Fund, up 23% so far this year, is among those that have benefited from the big run up in convertible prices. About 31% of its assets are in tech securities. Still, the fund has been dialing back its exposure to the most volatile AI-related securities, said co-portfolio manager Joe Wysocki.
Instead of ditching tech stocks outright, the fund has been trimming back on securities issued several years ago by companies such as highflying Western Digital and Seagate Technology and adding more recent convertible issues from companies such as Onto Innovation, he said.
The older convertible issues have enjoyed significant price run ups, meaning their values are at or above the price at which they can be converted to stock. That in-the-money dynamic ensures a convertible bond trades much like underlying stock.
More recent convertible issues tend to trade at prices well below the stock conversion price-these tend to show less volatility, trading more like bonds.
"As things appreciate, you sell in order to rebalance back," he said. "You're looking for ways to restore your risk-reward profile."
In other words, the AI trade is changing the convertible bond landscape. Investors who aren't prepared may find the sector has become riskier than they realized.
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