Swapping CCC rated bonds for convertibles: a smarter route to high yield returns?

Corporate bonds rated CCC – considered speculative with a significant default risk – have their place, but they typically involve drawbacks. Historically they have offered only modest incremental return relative to higher-quality high yield bonds, while introducing greater volatility, default sensitivity and liquidity risk. The modest return differential is primarily a function of higher coupon income (required to compensate investors for increased risk) minus credit losses from defaults and restructurings. Their increased volatility is primarily the result of higher default risk coupled with less liquidity/ownership.

We believe one option for addressing these drawbacks is to substitute convertible bonds in place of CCC rated paper. Convertibles, which give the investor the option to convert the bond into a predetermined number of shares, combine elements of a bond and a share. In the context of a diversified fixed income portfolio, they have the potential to increase returns while reducing dependence on distressed credits.

Looking back over the period from 1997 until May 2026, convertibles have tended to offer higher returns with less volatility than CCC rated bonds (Exhibit 1). Unlike traditional fixed income, their hybrid nature results in an asymmetric return profile. The embedded equity optionality creates participation in issuer upside, while the bond component can help moderate downside relative to lower-quality credit exposure.

Convertibles may offer diversification benefits within credit oriented portfolios. In the past 20 years, the ICE BofA US Convertible Index has exhibited a lower correlation to higher quality, high yield bonds – represented by the ICE BofA BB-B US High Yield Index – than the lowest quality segment, or CCC rated bonds (Exhibit 2). This relationship reflects differentiated return drivers. While high yield bond performance is largely tied to coupon income, convertible security performance is primarily influenced by the movement of the underlying equity, resulting in more varied sources of return.

This combination can enhance portfolio efficiency by reducing reliance on traditional credit beta. In periods when credit spreads, liquidity and default risk dominate high yield returns, convertibles may serve as a complementary exposure, potentially improving overall portfolio performance across economic cycles.

When viewed through a portfolio construction lens, substituting CCC exposure with convertibles has historically improved the efficiency of a high yield allocation. Since 1997, increasing exposure to convertibles has shifted the efficient frontier upward and to the left, delivering stronger performance for a given level of risk relative to portfolios with concentrations in lower quality high yield (Exhibit 3). By reducing reliance on binary credit outcomes and introducing positive convexity-based return characteristics, convertibles can help improve returns and reduce volatility over time.

Examination of upside and downside capture rates reveals another perspective on these diversification benefits. Exhibit 4 anchors market participation to quarterly returns of the ICE BofA BB-B US High Yield Index and shows that the convertible market’s upside capture is similar to the rate of CCC rated bonds. Studying the declining periods of higher quality high yield bonds, it’s clear the convertible market exhibits notably less downside risk.

Convertibles typically offer lower stated coupons than CCC rated bonds, so investors should evaluate the tradeoff between current income and total return potential. Performance may also be influenced by equity-market volatility, issuer-specific equity sensitivity and broader risk-off conditions. In sharp credit recoveries, lower-quality high yield may rebound more quickly, which can create periods of relative underperformance for convertibles.

However, we think that, in general, convertible securities offer a significantly higher return potential, demonstrate lower volatility and provide greater diversification benefits relative to CCC rated bonds. For high yield mandates seeking to reduce exposure to the weakest segment of the credit market, convertibles may offer a more efficient way to retain upside potential while improving diversification and downside resilience.