June 15, 2012
Written By Mark Salzinger
“Quite a few subscribers over the years have asked us about convertible securities funds, about which we have written little before now. Theoretically, such securities offer a compelling package: less risk than pure equities, combined with more income. However, holders sacrifice some potential for capital gains with most of these securities, versus holding their underlying stocks.
“In the current market environment, convertible bond funds make sense as a lower-risk alternative to small-cap equity exposure, especially for investors who prefer some current yield. Convertibles are hybrid securities, often issued by smaller companies with credit ratings below investment grade. They can be redeemed for stock (‘converted’) at a predetermined price and quantity. The equity conversion feature tends to make convertible values closely correlate to the value of the underlying stock, giving convertibles greater capital appreciation potential than a plain-vanilla bond. This is especially true when the conversion price is close to or even above the current price of the stock. Moreover, convertibles pay interest and return principal on a given maturity date, so the value of the bond portion of the convertible creates a floor under the security’s price so long as the issuer maintains solvency. This tends to make convertibles less volatile than stocks, although the small and lower-quality nature of most issuers somewhat counteracts the protective effect of the bond floor.
“This month we look at [two] no-load funds that invest in convertible bonds. Vanguard Convertible Securities (VCVSX) has generally outperformed over the 15-plus years that Larry Keele, of Oaktree Capital Management, has been at the helm, while volatility has been a little less than average. Cases in point: The fund’s five-year annualized return of 3.2% tops that of its average peer (2.9%) and small (less than 1%) annualized losses of the S&P 500 and small-cap Russell 2000. Also, in 2008, when convertible bond funds lost an average of 33.4%, VCVSX lost less than 30% (vs. a 37% loss for the S&P). The fund has suffered periodic bouts of underperformance. Last year, it was beset by exposure to cyclical companies (including airlines and energy) and weakness in specific selections among healthcare convertibles. The damage for the year was a loss of 6.8%, vs. 5.6% for its average peer, according to Morningstar. The fund has tended to rebound from losses, though: for instance, the 29.8% loss in 2008 was followed by a 40.8% total return in 2009.
“The portfolio holds only convertible bonds and convertible preferred stock; unlike many of its peers, it owns no common stock. Keele prefers convertibles with a ‘balanced’ profile: securities that have a reasonable yield (the fund recently yielded 3.2%) but good credit, with good call protection (which prevents the issuer from redeeming the bond if its price rises to a certain level) and low to moderate conversion premiums (the difference between the conversion price—at which you’d be able to convert a bond to stock—and the prevailing market price of the stock). The fund invests in about 200 issues, with heavy emphasis on convertibles with maturities of less than five years, and sticks to the upper tiers of below-investment-grade credit (BB and B ratings). … Last year, Vanguard expanded the fund’s mandate geographically; Keele now may invest as much as 30% of assets in foreign convertibles. … Earlier this year, Vanguard lowered the fund’s expense ratio to 0.59% from 0.68% and eliminated a 1% redemption fee on shares held less than one year. The minimum initial investment is $3,000.
“Fidelity Convertible Securities (FCVSX) is considerably more aggressive than its Vanguard rival, owing to manager Tom Soviero’s focus on the equity- related aspects of convertible bonds. Manager of this fund for seven years, Soviero has traditionally emphasized riskier companies but has taken a more measured approach recently, focusing on total return opportunities (income and capital appreciation) in the convertibles fund. Historically, the fund has been boom or bust. In 2008, its loss of nearly 48% was among the worst of all convertible bond funds; however, its 64%- plus rebound in 2009 was among the very best, as was its nearly 21% total return in 2010. … One reason for such a performance pattern is that Soviero prefers issues that trade in line with the movements of the underlying equity. Also, he wants the equity to have a low valuation, which brings many economically sensitive securities into consideration. He can hold 15% of the portfolio in common stock. Recently, Soviero has tempered the risk profile somewhat, holding just 3% of the portfolio in straight equity.
“However, Soviero continues to pile into his favorite ideas, both individual securities (the top 10 positions recently accounted for more than 38% of assets) and sectors (technology and consumer discretionary together made up 43% of the portfolio). … Credit quality of the portfolio is somewhat low, with less than 20% recently in investment-grade instruments, and nearly 38% CCC or below, or ‘unrated.’ Slightly milder economic sensitivity among fund holdings should help dampen volatility, which has been quite high on Soviero’s watch. Over the past five years, the fund’s standard deviation (which measures the severity of price swings) has been 47% higher than that of the average convertible bond fund, according to Morningstar. For long-term holders, the question is whether or not the volatility has been worth it. Indeed, over the past 10 years, the fund’s annualized total return of 6.0% has exceeded that of the Bank of America/Merrill Lynch All U.S. Convertibles Index by about 0.34 percentage points, which itself has exceeded the total return of the average convertibles fund by a considerable margin. The fund levies a 0.61% expense ratio and has a minimum initial investment of $2,500. It recently yielded 3.2%.”
Mark Salzinger, The No-Load Fund Investor, June 2012