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The Value Line Convertibles objective group covers mutual funds that invest the majority of their assets in an unusual and relatively obscure asset class—convertible bonds and convertible preferred stocks.  Indeed, convertibles are a mixture of a bond (or a preferred stock) and a warrant to purchase common stock in the issuing company. This creates a hybrid security with both bond-like and equity-like features. 

At times, a convertible bond can trade like a regular bond, based on the underlying company’s ability to make interest payments, interest rates, and other bond-specific factors. At other times, however, convertibles can trade more like stocks—typically when the value of the conversion feature (the warrant) is greater than the value of the bond. The end result is that convertibles often provide downside protection because of the bond component of the securities, but also upside participation if the stock price of the issuing company rises (though this participation is usually muted relative to a direct equity purchase). 

Mutual funds are one of the best ways for individual investors to participate in the convertible market because of the illiquid nature of many convertible securities. Also, small sales and purchases are often subject to large markups and trading costs, further reducing the benefit of direct purchase. Indeed, it would be difficult for an individual investor to cost effectively acquire a diversified portfolio at competitive prices.

The convertible market is small relative to the bond market and the stock market. Moreover, many issuing companies in this space are financially weak compared to the broader markets. Thus, managers here are generally selective in their portfolio construction. At the end of the day, the funds can be rather eclectic, and each needs to be reviewed carefully. Some managers tend toward more-aggressive, lower-quality holdings, while others prefer higher-quality investments. And these tendencies are subject to change based on market conditions.

Over the long term, the Convertible objective group has been a weak performer relative to the broader market, as measured by the Barclays Aggregate Bond Index. For the 10-year period ended August 31, 2012, the group had an annualized return of 6.5%, while the Barclays Aggregate Bond Index reported an annualized gain of 5.4%. Over the trailing five and three-year periods through August 31, 2012, the group had gains of 2.3% and 8.8%, respectively, while the Index reported annualized gains of 6.5% for both periods. During the past year, the Convertible objective group reported a gain of 5.4%, compared with a gain of 5.4% for the Index. Year to date through August 31, 2012, the Convertible objective group outperformed the Barclays Aggregate Bond Index. It reported a return of 6.9% compared with a gain of 3.9% for the Index. The group has a better-than-average Risk Rank of 2, indicating that funds in this group might appeal to more conservative investors.  

One fund with a relatively strong year-to-date return through August 31, 2012 is Putnam Convertible Securities Fund A (PCONX). The fund seeks, with equal emphasis, current income and capital appreciation. Its secondary objective is conservation of capital. The fund invests mainly in convertible securities of U.S. companies. 

A significant portion of the convertible securities it buys are below-investment-grade. The convertible bonds it buys usually have intermediate-to long-term stated maturities (three years or longer), but often contain “put” features, which allow bondholders to sell the bond back to the company under specified circumstances, that result in shorter effective maturities. When deciding whether to buy or sell investments, the fund may consider, among other factors: (i) a security’s structural features, such as its position in a company’s capital structure and “put” and “call” features (a company’s right to repurchase the security under specified circumstances is a “call” feature); (ii) credit and prepayment risks; and (iii) with respect to a company’s common stock underlying a convertible security, the stock’s valuation and the company’s financial strength, growth potential, competitive position in its industry, projected future earnings, cash flows and dividends. 

Another fund with better than average returns in 2012 is Franklin Convertible Securities Fund A (FISCX). The fund seeks to maximize total return, consistent with reasonable risk, by seeking to optimize capital appreciation and high current income under varying market conditions. The Fund invests at least 80% of its net assets in convertible securities (and common stock received upon conversion of convertible securities). By investing in convertible securities, the fund seeks the opportunity to participate in the capital appreciation of underlying stocks, while at the same time relying on the fixed income aspect of the convertible securities to provide current income and reduced price volatility, which can limit the risk of loss in a down equity market.

When choosing convertible securities for this Fund, the investment manager attempts to maintain a balance in the portfolio between the equity and debt characteristics of convertible securities with an emphasis on the equity features. The investment manager also considers the company’s long-term earnings, asset value and cash flow potential. Some of the convertible securities in which the fund may invest have been structured to provide enhanced yield, increased equity exposure, or enhanced downside protection. These securities typically provide a benefit to the issuer in exchange for the enhanced features, such as a conversion premium that is paid by the fund. Management may invest in convertible securities of companies of any capitalization size, but generally seeks to make its portfolio representative of the entire convertible securities market. The fund may invest up to 100% of its assets in securities that are rated below investment grade; however, it will not invest more than 10% of its assets in securities rated below B or in unrated securities of comparable quality. The fund may invest up to 20% of its net assets in other securities, such as common or preferred stocks and non-convertible debt securities. 

A third fund with a good relative year-to-date return for 2012 in comparison to the overall objective group is Lord Abbett Convertible Fund A (LACFX). The fund’s investment objective is to seek current income and the opportunity for capital appreciation to produce a high total return. Under normal market conditions, the fund pursues its investment objective by investing at least 80% of its net assets in convertible securities. The fund also may invest in synthetic convertible securities and convertible structured notes created by other parties such as investment banks. Under normal circumstances, the fund intends to maintain its average weighted maturity at between five and twenty years. The fund uses fundamental, bottom-up research to identify undervalued convertible securities that it believes may maximize total return and potentially reduce downside risk. The fund attempts to reduce the risks associated with these securities through portfolio diversification, credit analysis, assessment of their risk/return potential, and attention to current developments and trends in interest rates and economic conditions. The fund may invest in both investment grade convertible securities and lower rated (commonly referred to as ‘‘high yield’’ or ‘‘junk’’) convertible securities or, if unrated, determined by Lord Abbett to be of comparable quality. Reflecting the current universe of convertible securities, a significant portion of the fund’s Convertible securities may be rated below investment grade. The fund may invest
in companies of all sizes and may from time to time invest a significant amount of its assets in securities of small and mid-sized companies.


In the table below, we have listed 10 top-performing funds through August 31, 2012  that we follow in our Fund Advisor database.

 

10 Top Convertible Funds Performance

 

Fund Name

Ticker

% Year-to-date

Total Return

% 1 Month

Total

Return

% 3

Month

Total

Return

% 6 Month

Total

Return

% 5 Year

Total

Return

Annualized

Invesco Convertible Securities A

CNSAX

9.62

2.11

5.79

1.12

5.16

Vanguard Convertible Securities

VCVSX

9.66

1.51

5.78

0.88

4.37

Putnam Convertible Securities A

PCONX

9.38

2.12

5.73

0.40

2.76

Columbia Convertible Securities A

PACIX

8.48

1.60

4.59

-1.07

1.91

Franklin Convertible Securities Fund A

FISCX

8.11

2.56

5.31

-0.66

2.85

Lord Abbett Convertible Securities Fund A

LACFX

7.72

2.54

4.97

-0.88

1.56

Fidelity Convertible Securities Fund  

FCVSX

7.79

3.54

3.41

-3.27

1.40

Allianz AGIC Convertible Fund A

ANZAX

7.30

2.59

5.32

-1.37

  

Victory Investment Grade Convertible A

SBFCX

7.05

1.70

4.77

-0.56

-0.07

MainStay Convertible Fund A

MCOAX

6.80

1.57

5.07

-1.57

 

Convertible  Objective Group

  

6.85

2.01

4.81

-1.14

2.33