Do Volatility-Managed Portfolios Work Better for Convertible Bonds?

We extend the literature on volatility-managed portfolios to convertible bonds. Our volatility-managed convertible bond strategies take less risk when volatility is high, entail economic utility gains of up to 53%, increase Sharpe ratios and returns, and substantially reduce tail risk over their unmanaged equivalents out of sample and including transaction costs. The strategies exploit the mispricing of long-term options that results from the overextrapolation of short-term realized volatility. Their outperformance is concentrated in high-sentiment periods, during which they reduce exposure to sentiment-induced low market prices of risk and produce significant alphas and higher Sharpe ratios. As convertible bonds outperform equities in high-sentiment periods, they provide a valuable supplement to conventional portfolios. Combining volatility-managing with Markowitz’s optimal portfolio allocation out of sample expands the mean–variance frontier. An E-GARCH model enhances economic performance for volatility-managed convertible bond strategies compared to standard volatility-forecasting models.