What you need to know about convertible securities
April 08, 2013
If the idea of combining the income-producing potential of bonds with the opportunity for stock-like long-term asset growth appeals to you, you might want to consider investing in a convertible securities fund.
Oaktree Capital Management's Larry Keele, who manages Vanguard Convertible Securities Fund, answers questions about this type of investment, while Vanguard Advice Services leader Karin Risi addresses its potential role in a broadly diversified portfolio.
What is a convertible security?
Larry Keele: There are generally two types of convertible securities: convertible bonds, which make up about 88% of the holdings in Vanguard Convertible Securities Fund, and convertible preferreds.
A convertible bond is basically like any other fixed income security, with a coupon and a maturity date, but with an extra feature called convertibility. The owner of the bond has the right to convert it into a fixed number of common shares at any time for the life of the bond. Convertibility gives you the potential for equity-type returns—if the underlying stock price goes up, the value of the convertible also goes up and can easily exceed the par value—while still having the dependability of a fixed income investment.
A convertible preferred is a type of stock that pays income, usually quarterly through a fixed coupon with a higher rate than the regular common dividend. These investments are riskier than convertible bonds.
One reason is because bondholders come before stockholders in the capital structure; this means that, if an issuer goes bankrupt, bondholders will get their money back before stockholders.
Another is because, unlike convertible bonds, convertible preferreds lack a maturity date. Convertible preferreds have greater equity upside potential, but they're definitely more volatile on the downside. We invest in them in Vanguard Convertible Securities Fund, but we're very careful when selecting them.
The most common issuers of both convertible bonds and convertible preferreds are non-investment-grade-rated companies. The convertible securities may be nonrated or rated below BBB– from the major rating agencies, such as Moody's or Standard & Poor's. An interesting point to note is that most companies that issue convertibles don't default on their obligations, but credit analysis of each issuer is important because there is that risk.
Source: Securities Industry and Financial Markets Association (SIFMA) Bond basics page.
What do you look for when selecting investments for Vanguard Convertible Securities Fund, especially in terms of risk?
We're looking for convertibles that we believe have an imbalance of upside potential to downside risk. Any time you buy a convertible security, you're exposed to the common stock. That means the current value of the bond is highly affected by the value of the stock. Obviously, the stock market is much more volatile than the bond market—and interest rates. We seek to buy individual convertibles that we believe have a stronger ability to make money on the upside, where we're capturing 65%–90% of the upside move of the common stock, but are only exposed to 30%–50% of the downside in the short to intermediate term.
We use a bottom-up process, which focuses on the convertible security first. The main things we emphasize are structure, creditworthiness, and potential for underlying equity appreciation.
First, the structure: Is it a bond or preferred stock? What's its price and yield? What's the maturity date if it's a bond? Does it have a low to moderate conversion premium (which is the difference between a convertible security's price and its value if converted into common stock shares at the current stock price) and sufficient call protection? Call protection means the company can't call the issue at par, which is its face value, for a specific period of time—the longer the call protection, the better. We evaluate the bond's coupon, credit quality, and maturity to minimize the downside risk, while low-to-moderate conversion premiums and good call protection help us capture the upside.
The next step—credit quality review—is really important. Oaktree is known for its expertise not only in convertible securities but also in high-yield bond and distressed debt management. There's some overlap between the convertible and high-yield bond markets, so our analysts in those areas are able to collaborate on the credit quality of each issuer.
For each company, our team typically looks at 30–35 credit metrics and analyzes the trends over time. Because most issuers are B or BB rated, or don't have any rating at all, either because they choose not to pay for a rating or they're too new to have one, you really need experience evaluating credit to invest in the convertible securities market.
Finally, after thinking about the downside risk, we look at the stock and its potential for capital appreciation. If we feel relatively protected on the downside and the upside potential looks to be attractive, we'll purchase the security.
What return on investment is reasonable to expect?
Of course, our long-term returns depend on the equity markets, so you won't always see a steady bond-like return with Vanguard Convertible Securities Fund. That said, we hope to achieve high single digit returns over time. It's about the same as you'd expect from stock market returns.
In the short run, we're not going to capture all the stock market return if the market has a very strong advance, where it's up 15%–25%. If the stock market advances in the 5%–15% range, we should capture a large percentage of that return. But if stocks are down, we should have downside protection and solid relative performance.
What types of risks do convertible securities funds have?
Vanguard Convertible Securities Fund has equity risk. Its biggest correlation, which is a measure of how prices move together, is with small- and mid-cap stocks, including numerous growth companies that issue convertibles to meet their capital needs. We don't have much exposure to large-capitalization equities, so if they're outstanding performers, our fund's performance is likely to lag the overall equity market.
Credit risk is another important factor to consider when investing in convertibles. Oaktree's history in managing credit risk has been strong, and we're confident that will continue going forward. Vanguard Convertible Securities Fund's portfolio is also highly diversified, which helps negate the risk of being overweighted in any one issuer or industry.
Of course, there's always general market risk. Nearly all markets have advanced over the past few months. If you're selling equities to buy convertibles, that's one way to help control your volatility but stay invested. If you're just getting into the market for the first time, convertibles offer a reasonable and defensive way to give you equity exposure.
We have a very defined sell discipline where we take profits from highly appreciated securities out of the Convertible Securities Fund. As convertibles move up in price, they become more like their underlying stocks; their yields-to-maturity go increasingly negative and their downside risk increases. Our sell discipline helps us manage this risk; we take the proceeds and buy new securities closer to par with the balance of upside potential/downside risk.
By definition, convertibles aren't as safe as 5- or 10-year U.S. government bonds. On the other hand, I believe the return potential is much greater over the intermediate to long term.
I'm not an expert investor. Should I consider a convertible securities fund?
Karin Risi: While convertible securities are often thought of as a "niche" investment product, they might be worth taking a look at. With convertibles, you can get equity-like exposure with a record of lower volatility than what you might experience with "pure" stock investments, along with a history of a reasonable level of current income.
Of course, there's no free lunch in investing. You'll want to keep in mind that many issuers of convertible securities have below investment-grade ratings. Also, you could be sacrificing some upside return potential for less volatility.
How could I use convertible securities or a convertible securities fund in my portfolio?
Karin Risi: In our experience, people who invest in Vanguard Convertible Securities Fund are looking for a less volatile way to get long-term, equity-like returns rather than investing in traditional equity shares alone. You can think of convertibles as an equity alternative and we would view the position as part of your equity allocation.
Recently, many investors have included the Convertible Securities Fund in the bond allocation of their total portfolio. They look at it as an opportunity to enhance their fixed income returns, and are willing to accept the higher risks associated with this type of investment over a traditional bond fund.
A word of caution about this approach; it could change the risk profile of your portfolio. In our view, the role bonds play in your portfolio is to diversify equity exposure, with its associated volatility, in long-term portfolios. Given that convertible bonds have a higher correlation with the equity market, using them to replace bonds in your allocation could dampen the benefit you'd get from greater diversification during periods of market volatility.
- All investments, including a portfolio's current and future holdings, are subject to risk.
- High-yield bonds generally have medium- and lower-range credit quality ratings and are therefore subject to a higher level of credit risk than bonds with higher credit quality ratings.
- Past performance is not a guarantee of future results. Investment returns and principal value will fluctuate, so investors' shares, when sold, may be worth more or less than their original cost.Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer's ability to make such payments will cause the price of that bond to decline. Diversification does not ensure a profit or protect against a loss. Prices of mid- and small-cap stocks often fluctuate more than those of large-company stocks.