Balanced Risk Reward Through Convertibles

Invesco Convertible Securities Fund

US > >

Oct 14, 2013
  • 52 Week HL
    166.21 - $129.06
  • Net Assets
    $21031.5 M
  • Expense Ratio
  • Inception Date
    Jan 02, 2002

Q:  What are convertible securities? A : Convertibles are essentially a hybrid security. They are made up of two securities - fixed income and the stock of a company. They are linked by an equity option, which allows the holder to convert the bonds to stock if the shares reach a certain price. The hybrid aspect of the security allows the equity sensitivity, or the delta, to self-adjust depending on the performance of the underlying stock. The fixed income component gives you some downside protection because you have a maturity, and also you are getting paid interest every six months. In addition, convertibles can provide upside participation with the equity markets due to the embedded call option. We consider convertibles to be the defensive approach to equity: investors are paid to wait via the semi-annual coupon payment, the yield of convertibles typically exceeds the yield of the underlying equity, and convertibles provide asymmetric returns by participating in a greater portion of their stock’s upside, than their downside. They also have shorter durations than straight fixed income, with the average duration being two years. They also typically have less volatility than the broad equity market, as measured by the standard deviation. Q:  What is the nature of the convertible universe? A : The universe is currently about $200 billion. It is made up of small, medium, and large cap companies, and at least 500 companies issue convertibles. Investment-grade makes up 25% of the universe, but the majority of the universe, 40%, is non-rated. Non-rated does not mean they are junk; rather, the companies do not want to take the time, or spend the money, to go to the rating agencies. Typically convertibles are issued with a one-day marketing period, so you can issue securities quickly and on occasions there is not enough time get rating agency evaluation completed. With 40% of securities non-rated, the investor determines the underlying credit rating, which emphasizes the importance of a rigorous credit research process. The majority of the companies are small and mid cap, even though there is a large cap component to the marketplace. The largest sector in the universe is technology, followed by consumer non-cyclicals, including healthcare. Healthcare, and in particular, specialty pharma are big issuers of convertibles. Most of the time companies issue convertibles because it enables them to get a lower interest rate by giving up some of the equity. The biotech companies issuing convertibles are typically profitable, but many of them are burning cash, and that is why they need access to capital. Convertibles offer companies a way to finance their cash burn and fund the research and development. The reason they issue convertibles is because it lowers their coupon, so it allows the investor to get paid to wait for profitability. Q:  What is the history of the fund? What are some of the key attributes of the fund?? A : I have been lead manager of the fund since 1998. Ramez Nashed is co-manager. He joined the fund in 2000 and became a portfolio manager on the fund in 2006. The two of us are managing the fund, which currently has $1.5 billion under management. We joined Invesco from Morgan Stanley Investment Management in 2010 as part of Invesco’s purchase of Morgan Stanley’s retail asset management business, including Van Kampen. At the time the fund had about $300 million in total assets. We manage what we consider a “pure play” convertible fund. We are 100% invested in convertible securities. We do not buy common stock in the portfolio; however, we will hold common stock as a result of conversion. We will not buy synthetics, which are a structure whereby a broker-dealer will structure a convert using their balance sheet. We do not like the lack of transparency of a synthetic structure. We do not like that you are beholden to one counter party. We do not buy straight fixed income in the portfolio. The fund is all U.S. dollar denominated. We do not take any currency risk. We also run a fund that is fully invested. We typically do not carry large cash positions. We also run a well-diversified portfolio where our top 10 holdings are approximately 15% of the total portfolio. The largest holding in our portfolio is approximately a 2.5% weight. What makes us unique is our focus on buying convertibles for upside participation and downside protection. That is why we do not get involved in buying common stocks in the retail market. We feel that our investors are looking for that upside, but they really want the downside protection as well. Q:  What is your primary focus? A : We believe managing through the cycle is a better long-term strategy, and we go back to our belief that we want to capture the upside participation while also seeking the downside protection. We look for traditional convertibles that offer a balanced risk/reward profile. We seek to find those companies that offer approximately 60% to 70% of the upside, with only 30% to 40% of the downside. Risk management is a key to our long-term performance. By constructing a well-diversified portfolio, we believe we can achieve strong long-term performance with lower risk. We believe that managing a dedicated convertible portfolio is the best way to provide equity exposure with less risk. Q:  What is your investment process? A : We focus on traditional converts and we look for companies with strong balance sheets, a clear business focus, and competitive advantage versus their peers. Then we seek to add alpha or generate additional return to benchmark through careful credit analysis and security selection. We look at the universe, which is the Bank of America Merrill Lynch All U.S. Convertibles Index from a bottom-up perspective. For us, it is all about analyzing the underlying equities. Once we screen the universe and identify those bonds that look attractive to us, we then become equity investors and do a fundamental research on the underlying equity. We want to determine whether there is an upside to the underlying equity. If we like the underlying common stock, we will then buy the convertible bond. If we do not like the underlying equity, we are not going to purchase the security. We utilize what we call a “barbell” approach, whereby we aim to target the equity sensitivity of the portfolio based on market conditions. We also try to take a longer-term approach to investing and we manage through the cycle, which we feel is a better long-term strategy than managing the cycle. Q:  Can you explain in detail your barbell investment approach? A : The barbell approach is almost like a C-style, where the middle is traditional convertible bonds that offer that balanced upside/downside as the core of the portfolio, which is around 60% to 70% of our holdings. We then balance that on both sides. To the left of the barbell would be your “busted” convertibles, where the equity option is out of the money. These bonds trade more like a straight bond and have less equity sensitivity, but provide above-average yields to maturity. To the right of the barbell would by your more equity-sensitive convertibles, which are more common stock-like in nature, and less bond like. They offer the most equity sensitive names and they typically trade at higher delta. That gives you more sensitivity to the underlying equity. We move along the barbell depending on our macro views. We can dial up and down that delta, depending on our views of the market. Because this is a diversified index of 500 names made up of small-, mid- and large-cap companies, as well as growth and value companies, we have to look at different ratios based on the different sectors and different companies we are looking at. For example, if it was a healthcare company, a biotech company, that will be different than if you are looking at an energy company. In general you are looking at competitive advantages, revenue growth, earnings growth, and a diversified business. To put it in perspective, what we want to try and avoid is the yield trap. For example, if you were running a liquidity analysis, obviously, you are not going to get involved in investing in the bond unless the liquidity analysis checks out. For us that is not the end of the work we do - it is only the beginning. Obviously, you will not get involved in a bond unless it will be fully paid, but as the convert investor, you also would like to realize the equity option. You find yourself having to dig into the business plan and understand it for the company. Do you believe in that business plan? Can they execute on it? If that is something we doubt, then we probably will not get involved in the bond, even though the optics do look attractive. Just based on financial data that was in the public domain, Eastman Kodak, for example, before they filed, had ample cash on the balance sheet, and they only had one convertible. The main reason we did not get involved with the convertible security was because we did not understand, and could not believe, that they could execute their strategy. The balance sheet will always drive the income statement. If you are not in sync with the management’s capabilities of executing, then we will not get involved in the bond. We also do credit work, especially if we are looking at the busted part of the universe where you have above-average yields and you are looking at bonds trading at 60 cents to 70 cents on the dollar. We look at real credit stories rather than being driven by the underlying equity. We need to know that credit will get paid off at the end of the day. Q:  What is your research process and how is your research team organized? A : The fundamental research we do is to get to know the names from an equity perspective as well as from the debt side, and then come to a conclusion based on that. Ramez and I split up the universe by sectors. It is just the two of us on the convertible team, but we are also part of the larger Equity Income team, which manages $20 billion, of which about 10% to 15% of that is invested in convertible securities. That team has four senior portfolio managers, also broken up by sectors. We work with that team on ideas, and we consult with them on their convertible ideas, although we do not make those buy and sell decisions. Because they do “deep dive” research on many of their names, they are a good resource for us to tap into when we are looking at names in the convertible universe, especially on new issues. New issues are typically one-day marketed deals, so to do that deal in one day, if you do not know the underlying equity, makes it tough. Ramez and I, being a small boutique within this resource-filled organization of Invesco, can tap into both the equity and income teams, as well as other managers within the firm. We manage fewer than 150 securities, but some of them are from the same issuer. We screen the universe looking for names, and then we look at the underlying equity and determine whether we like the fundamentals on that underlying equity. That is the starting point for us. We believe the traditional part of the marketplace is the sweet spot for convertible investing. With convertibles, you are not put in a style box. With most other funds you are either small, mid, large equities, or you are growth or value, or you are GARP. With convertibles, you can be all of those at any different time, a combination of, or tilted towards one side of the other. Depending on market conditions, we can tilt ourselves in whatever direction we believe we are moving in. Again, this is the barbell strategy, where we can dial up or down the equity sensitivity of the portfolio based on our investments, by letting the more equity-sensitive section of the portfolio continue to run, or we can tilt more towards credit-sensitive, as we did back in 2008. We outperformed our peers because we had less equity exposure. We are benchmark aware but not driven. Even though our benchmark is the Bank of America Merrill Lynch All U.S. Convertible Index, we will take steps from a bottom-up approach to select sectors that are either overweight or underweight the index at any given period in time. Q:  What is your portfolio construction process? A : We construct the portfolio to focus on what we think is the “sweet spot” of the convertible marketplace, which is that “traditional” convertible that offers that 60% to 70% of the upside, with 30% to 40% of the downside. That is the majority of the portfolio and our core focus. We initially start out with having those convertibles as a big chunk of our portfolio ,and then add, based on our views of the underlying equity, more equity-sensitive names, or allowing our traditional names where our fundamental thesis works out, to allow those securities that become more equity-sensitive to stay as a portion of our portfolio. That moves it more towards the equity-sensitive side. At the same time we are still looking at the left side of the barbell, which is the busted side, where we find that you can get mispriced credits at above average yields to maturity, and get paid to wait until those stories turn around and the credits improve. We are trying to identify credits or names that have been left for dead in the marketplace, because it requires work to be done on those securities, and the marketplace has not focused on them. It provides an opportunity to pick up mispriced credits and get paid to wait. That adds income at the same time. You are getting paid, although you are not really moving with the underlying equity, but that above-average yield is enough to offset that, even if the stock continues to go lower. By constructing our portfolio with a focus on the middle of the portfolio, but having both equity-sensitive and credit-sensitive converts in the portfolio, we feel that gives us above average returns with less volatility. We look at the benchmark and we understand where our weightings are in the different sectors, and if we are underweight the names that we are comfortable holding, then we are not uncomfortable having an overweight or underweight to those specific sectors at any period in time. For example, in 2008 we were at half the index weight in financials, which served us well. We were not uncomfortable being at half the index weight because we knew the fundamental reasons why we were underweight. We think diversification is an important part of the process, and our philosophy is to run a diversified portfolio. The top 10 holdings in our portfolio are typically under 15% of our total holdings. Based on that, the other 85% of the portfolio is well-diversified. Most of those positions are around 1% of the portfolio. We like to stay focused on maturities of three to five years if we can.

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The history of the fund actually starts before it was established. The team came together at the end of 2003. Using the same strategy we employ today, we primarily managed institutional international and global equity portfolios.

The history of the fund actually starts before it was established. The team came together at the end of 2003. Using the same strategy we employ today, we primarily managed institutional international and global equity portfolios.