Executive Summary
From niche market to the center of attention? Convertible bonds – i.e. corporate bonds with an attached equity call option – are often overlooked in asset allocation but their performance in 2025 has sprung them into the spotlight. Over the last 30 years, convertibles delivered 70% of equity returns but with only 35% of the volatility (6.7% p.a.). 2025 has topped this performance, with convertibles outperforming both equities and bonds (Sharpe ratio 2.0 vs. 1.0 and 0.1), helped by falling interest rates, the rise of technology, balanced technicals and resilience during volatility. The attractive yields, moderate conversion premiums and healthy new issuance reinforced the technical strength of the market. Global issuance hit a five-year peak of about USD81bn, driven by growth sectors like tech and biotech, as well as companies seeking flexible funding amid elevated rates.
Convertibles offer a unique blend of appealing bond and equity features, making them a highly attractive option for both corporates and investors. Investors receive the downside protection of a bond but benefit from the upside potential of equities when market performance is strong (on average starting at >6% p.a. equity performance). Corporate issuers are particularly attracted when facing higher financing-cost pressures as the equity option lowers the burden. This is of particular value to growth companies and during restructurings, both of which are highly represented in the US, which accounts for 75% of issuance and outstanding volume. Moreover, convertibles are hardly a speculative asset: The credit quality of these investments has improved significantly, with a blend of investment grade, high yield and non-rated. As a further mitigant, short-duration (1.5 years) has been shown to reduce risk.
The performance of the market is being driven by the macroeconomic regime as well as equity and bond fundamentals, particularly in the technology and small-cap sectors. The value of convertibles is driven by stock option value and valuation, as well as the bond's yield. Higher volatility tends to increase convertible prices, while rising rates or widening spreads tend to decrease them. We define Yield to Worst (YTW) as a key indicator of downside risk, with lower YTW indicating minimal yield provision and reduced stability. Convertibles demonstrate strong performance during periods of market crises, due to their role in providing protection through bond instruments. But in robust bull markets these instruments tend to limit equity sensitivity (Delta) to below 1, resulting in suboptimal performance. A factor analysis reveals a notable exposure to smaller, less mature firms with lower profitability. This also explains the underperformance observed during periods of tightening cycles and the absence of substantial momentum from the large-cap technology sectors, especially between 2022 and 2024. Despite occasional setbacks, convertibles have proven resilient, offering greater upside than downside, making them a less cyclical and more stable investment . This return asymmetry is of particular importance for the small-cap theme to play out as their greater performance dispersion can be utilized more efficiently, thereby participating from rising stars and cutting laggards to its bond value (positive selection). Looking ahead, AI-driven capex and decarbonization projects are likely to anchor the next wave of convertibles, as firms use equity-linked debt to finance large, uncertain investments without overloading balance sheets.
Current market conditions – moderate growth and episodic volatility – are ideal, and our AI-enhanced forecasts suggest a strong 12-month forward return of 11.4%. This is significantly higher than the historic 70/30 equity-bond split at 9%, based on our forecast. This high optimism is based on low business sentiment, economic uncertainty (as the AI-bubble sentiment reverberates through markets) and attractive small-cap valuations, market conditions that have historically supported strong convertible bond performance. Rational earnings expectations of smaller companies, and high equity volatility are also positive drivers, creating a favorable environment for convertibles, most comparable to 2016 and 2019, as identified by our cluster algorithm. While history may repeat itself, we recognize the fundamental differences between this period and previous ones, particularly the historic low yield to worst and the absence of equity market corrections in recent years.
Ultimately, convertibles can enhance diversification and improve risk-adjusted returns. Adding convertibles to a portfolio shifts the efficient frontier outward, i.e. offering higher returns with lower volatility. To reap the benefits, investors should understand the nuances. First, benchmark selection is critical because convertible indices vary widely in composition: broader indices often outperform narrower ones but may include less liquid bonds. Second, active management is recommended to navigate the market's hybrid nature: Active managers can adjust their exposure, capitalize on new issuance discounts and navigate call provisions, while passive strategies may lack flexibility and miss opportunities.