A surprising opportunity for income seekers

After 2 interest rate cuts by the Federal Reserve, yields on some popular short-term investments such as short-maturity Treasury bills, high-yield savings accounts, and money market mutual funds are earning attractive yields on investors' portfolios as interest rates on many fixed income products come down. That may make this a good time to look farther afield for places to put an investor's money where it can continue to earn attractive yields.

Adam Kramer, portfolio manager at Fidelity, invests in a wide variety of income-oriented assets. He invests in a wide variety of income-oriented assets. As he looks forward to 2025, Kramer believes there might be especially attractive opportunities in the convertible bonds that an increasing number of companies are issuing to raise capital to fund their growth and operations.

What are convertible bonds?

Convertible bonds are securities that pay interest like other bonds, but which also may be converted to shares of the issuing company’s stock. The conversion of a bond to a stock may take place at a predetermined ratio of stocks per bond, which effectively results in a predetermined stock price. That means an investor may be able to buy a company’s convertible bond and get paid an attractive interest payment—known as a coupon—while an investor waits to potentially convert the bond to stock in the future. As Kramer puts it, "Convertible bonds are unique because they pay interest like other bonds but their prices also move with the issuing company’s stock."

Why are convertible bonds attractive now?

Kramer believes that convertibles are one of the few fixed income markets still offering real value available as 2025 approaches. They not only offer attractive yields, they also can enjoy future potential gains in the stock market that many investors are expecting in the next few years if deregulation and tax cuts help boost US stock prices. Supply-and-demand dynamics in the convertible market also are creating opportunity. Unlike other assets, previously issued convertible bonds are continually “leaving the market” as they convert to stock and new issues with different features are taking their places. One-third of convertible bonds currently in the market will mature by 2026, and half by 2027, creating pent-up demand for new issuance.

Another benefit of convertibles is that they reduce some of the potential drawbacks of both stocks and conventional bonds. Convertible bonds generally are less sensitive than many other bonds to the risks that changes in interest rates may pose. Convertible prices can fall if interest rates rise and stock prices decline, but they are less sensitive to such changes than both stocks and traditional corporate bonds. Like other bonds, convertible prices are likely to rise when interest rates fall.

Before investors consider convertibles, they should remember that the convertible bond market is both small and specialized, and conditions in it can change quickly. Investors should also keep in mind that while convertible bonds may offer more predictable returns than the same issuer's stock, they also present credit risk, particularly if issued by smaller, less well-capitalized companies.

What's the future for convertible bonds?

Small though it may be now, the convertible market is growing. “I wouldn't be surprised if convertible bonds are going to be a bigger part of the market in the next few years,” says Kramer. One of the reasons for his optimism is that more companies' leaders appear to be recognizing the helpful attributes of convertibles as tools for raising capital for an increasingly wide variety of purposes.

“I think now we're entering a golden age of convertible bonds,” says Kramer. “We're starting to see some really interesting deals come to the market.”

One example of this is a software company, which has already issued $6.2 billion worth of convertible bonds this year to buy bitcoin and plans to issue $21 billion more worth of debt, mostly convertible bonds, over the next 3 years to buy even more bitcoin. Kramer notes that in 2024, this company's convertibles have increased in price by more than bitcoin has risen over the same time period.

“Their convertible bonds have outperformed bitcoin. All of the convertible bonds they issued in 2024 have either doubled or tripled, which means the company is essentially debt-free now and can reissue new convertibles in 2025 as the existing bonds convert to stock. This example is unique because the company's sole purpose is to buy bitcoin and 95% of its assets are in bitcoin, so the company’s volatility is closely tied to the price of bitcoin. Because of that, they can issue convertibles with different sensitivities to their stock, which there is a big appetite for. From my perspective, being a debt-free company helps provide downside protection and the company has a lot of unencumbered asset value along with equity upside tied to bitcoin, which can appreciate over time," says Kramer.

The rise of bitcoin is also creating opportunities elsewhere in the convertible market. "Bitcoin miners are evolving their business models and issuing convertible bonds. They’re repurposing their large data centers—originally used for bitcoin mining—to partner with AI companies, aiming for less risk and higher profitability," says Kramer.

Beyond bitcoin

While some companies and bitcoin miners have gotten plenty of attention, Kramer also sees opportunities as many other companies enter the convertible bond market. Just as the software company's convertibles (in the example mentioned earlier) gives investors an indirect way to invest in bitcoin, other companies’ convertibles can provide an alternative way for investors to access other companies or investment themes without buying their stocks and while also collecting a coupon. “For example, an airline company has issued $5 billion in convertibles with very attractive terms as part of their effort to fix their balance sheets. It’s an opportunity to get paid an attractive yield while you wait for the company to solve its current challenges and for its stock price to eventually recover.”

Kramer and Rick Gandhi, who co-manage a Fidelity fund, also point to small-cap companies in the nuclear energy, renewable energy, and data center businesses that have been issuing convertible bonds as good ways to get exposure to industries that may grow rapidly in the years ahead.

How to invest in convertible bonds

Professional management and research can help you manage the risks that come from venturing into less-common income investments such as convertible bonds. Investors may want to consider gaining exposure to convertible bonds through multi-asset income strategies that also invest in other income assets as ways to diversify away some of the risks posed by having concentrated exposure to a single asset class.