Consider Convertible Bonds to Capitalize on Healthcare Growth and Minimize Portfolio Risk

Healthcare spending is becoming a larger share of GDP and an increasingly important sector of the economy to watch. Representing almost 20% of the economy and expanding over the foreseeable future, healthcare is a growth industry presenting opportunities and risks for investors. Convertible bonds may offer an attractive way for investors to capitalize on this growth while minimizing risks.

According to the Centers for Medicare and Medicaid Services, National health spending is projected to grow at an average annual rate of 5.4% for 2019-2028 and to reach $6.2 trillion by 2028.  This suggests that as a share of the economy, healthcare will rise from 17.7% in 2018 to 19.7% in 2028.  (Source: CMS.gov).

Americans are growing older and these changing demographics will fuel the growth in healthcare spending. Navigating the rapidly changing industry and complex regulatory environment can be challenging. Fortunately, the healthcare industry is quite familiar with the convertible bond market as a source of financing providing a plethora of investment opportunities for investors.

As the following chart depicts, there currently exists almost 100 publicly traded convertible securities across multiple healthcare subsectors.

Pier 88’s research suggests that the above issues represent large, mid and smaller capitalization companies with a range of market caps from sub $20 million to almost $400 billion, with median of about $1.5 billion. Including in this mix are household names like JNJ, DHR and ANTM. Interestingly, the yield on the ANTM convertible bond is superior to the dividend on ANTM’s common stock. There are also many less well-known names where a savvy investor can find quite intriguing risk-reward opportunities. Some names are low delta – meaning the security’s move is less influenced by the movement of the underlying stock, and the issue behaves more like a traditional bond. On the other hand, some issues are high delta and a closet way of gaining exposure to the underlying stock.

So why might an investor want to invest in a healthcare company’s convertible instead of the common stock? We submit that a convertible bond often offers a different risk profile than the equity. Often times the risk profile of the convertible is superior. Convertibles can offer equity participation with downside protection. The year-to-date performance of the healthcare convertible market this year is quite illuminating. Pier 88’s Investment Team compared the year-to-date performance of approximately 100 publicly traded convertibles with the performance of the underlying equity. The results are described below:

On a year-to-date basis, the total return of the convertible bested the performance of the equity for almost 70% of the healthcare companies. Upon further review, it appears this result is driven by the more defensive attributes of the convertibles relative to the equity. The stocks of 80% of these companies have negative returns this year. This is a rather short time period of measurement, yet the broader market has been quite volatile and offers some interesting insights. In addition to these defensive qualities, convertibles can and have participated in the upside of the equity. For instance, the equity of a telemedicine provider has appreciated over 100% this year and this company has two convertibles; one has appreciated 88% while the other has increased 98%. Strong fundamentals are behind this appreciation. The company experienced a surge demand driven by the COVID-19 shelter in place orders. Effectively, the virus had the unintended effect of accelerated adoption. The company positively pre-announced Q1 growth of over 40% YoY and is forecasting growth over 45% for 2020. Not many companies will be able to deliver that level of growth in 2020.

The fallout from the COVID-19 pandemic and Shelter-in-Place rules have created uncertainty for the economy. Many publicly traded companies will likely pull 2020 guidance creating more confusion and dispersion. The convertible bond has offensive and defensive properties and may present a very compelling way to gain exposure to the dynamic healthcare industry.

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Frank Timons, Portfolio Manager
Frank Timons is CEO and CIO of Pier 88 Investment Partners, LLC, investment Sub-Advisor to a convertible bond strategy at Rational Funds. He was previously a Portfolio Manager at Lord Abbett & Co. for the convertible, large cap core, and large cap value strategies. Frank also served as a Research Analyst at Lord Abbett & Co and Robert W. Baird & Co. Frank holds a B.A. and J.D. from Notre Dame and MBA from University of Chicago.

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