Q:  How do you define your investment philosophy? A : Convertible securities investing requires a special understanding of credit quality and capital structure of the companies to be evaluated. We believe that most investors lack a holistic approach to this difficult to invest in and illiquid, yet sometimes fast moving market segment. At Putnam, we have expertise in various market caps and investment styles, spanning from local to international markets that most other investment houses may be short of. Our breadth of capabilities in credit research and equity analysis provides us with understanding of companies and sectors, and gives us a degree of confidence to act on at short notice, which is always necessary in this marketplace. By saying that we are holistic in our view, we mean that if there is an opportunity or a risk to be managed with regard to equity, credit, or structure of convertibles, we will consider that. Q:  How is your investment approach different from other asset managers? A : The majority of our competitors are equity oriented and they focus on stock research and growth outlook. They are less interested in credit opportunities as well as less interested in the attractiveness of the discount of these instruments, which they mainly leave to arbitrageurs. There are many arbitrageurs that concentrate only on the cheapness of the instrument, because either they are shorting stocks, or using credit default swaps to manage credit risks. Lastly, I think there are a few boutique players who are very credit oriented and, essentially, are distressed bond investors within the convertible space. We are very familiar with that activity as well, but we look at all three aspects when we make a decision. Q:  What does a convertible bond fund give to investors, other than what they could get from investing in a plain equity or a bond fund? A : On the surface, convertibles are a blend of stocks and bonds. You will find the argument in many quarters that, for that reason, you may want to stay away from them because you can mix stocks and bonds and achieve essentially the same result. In practice, what you find in the convertible market itself is that returns over the long-term have been better than people would expect to get by simply blending stocks and bonds. It is certainly true that you could have a balanced portfolio or an equity/income fund, and be positioned in the same risk space, but then you are likely to be value-oriented. If you add convertibles to that mix, you can get a little more core and growth orientation without changing your volatility, or without sacrificing income. The convertible market tends to be inefficient because at times it is less liquid and convertibles are not as well known, on average, as stocks and bonds. Furthermore, convertibles are biased towards smaller companies, which, over time, have tended to outperform large companies. They are also biased towards lower credit quality companies which, in the last three or four months, has not been helpful, but over time, there is a tendency for those to outperform higher credit quality bonds. In addition, active fund managers are likely to be successful in this space for the same reasons. Convertible issuance activity is opportunistic and growth companies often access this market. The interesting thing is that we can create a product that does not appear very different from a balanced fund in terms of its yield, volatility, and sensitivity to the broad equity market. The composition of this product is tilted a little bit to the growth side, which is helpful to investors who are in this income and growth space and are confronted with mainly value securities of mature companies in real estate trusts, pharmaceuticals and banks. Using convertibles will enable them to gain some valuable diversification. Q:  What is your research process? A : Since convertible issues come into existence on a short notice, all of us are set up to act swiftly. The research process on new deals is very limited in time as issues come and go quickly. We have a four-person team focused on equity, fixed income, trading, and research. When we get an approval on the credit or equity side from one of our researchers, depending on whether equity or credit is more important and who covers it, we will consider that along with whether or not the instrument is cheap. One of our team members is a full time trader – half time on convertibles, half time on other securities – who checks in with the underwriters and other market participants to sense how each play is likely to come out of the deal. In terms of the aftermarket, where we also buy and sell, we tend to run various screens on percent cheapness of the convertible yields-to-put. We see if we can identify any yield ideas in this market because, quite frequently, non-dedicated convertible owners will give up on equity of the issuer. They will sell or convert at the wrong price and that will provide us with a yield-to-put or yield-to-maturity opportunity. We do run many screens of that type. Also, the convertible market turnover is near 30% a year, whereas it is about 4% in the s&P 500 index so the time that you dedicate to a specific issue is much less than one would spend in analyzing a stock. Q:  Could you give at least one example that highlights your credit research process as well as your equity research process? A : In 2002, elan Pharmaceuticals, an ireland-based pharmaceutical company, got into serious trouble. Their stock declined over 95%. In addition, the company had a convertible security outstanding that had the put option feature that was due to expire in less than a year. The return to that put was about 85% upside. It had an annualized yield-to-put of about 100%. One would assume this was a risky credit hanging on the edge of bankruptcy. They had over $800 million in cash, but they needed about $1.1 billion to meet this put. There had also been some financial irregularities and management problems, but they had been resolved and an individual from the board with a background in biotechnology and medical devices, who i had known from prior dealings on Wall street, had come on to run the company. We quickly concluded that their plan was not to put the company in bankruptcy, but they were rather trying to survive, as one of the largest employers in ireland. When we did the research we realized there were many close-to-market products and a lot of r&d they had not commercialized. We felt that probably they could sell some mature products and that is exactly what turned out to be the case. They sold one mature product to king Pharmaceutical for $800 million. Once that sale went through, the put had a real value and we ended up making a very high return on the security within a short period. Another example is lockheed martin Corporation, the U.S. defense contractor, that issued a convertible bond a few years ago and it was called this year. When they first issued a floating rate bond it was not popular at all, and the company did not need money, unlike most companies in the convertible market. They issued it with a floating rate and back in 2002 rates seemed to be going lower. At first, we were not particularly interested in this, even though the credit quality was strong, but we just could not see the upside. After a while, investors were convinced that peace was breaking out everywhere as the us had prevailed in the first part of the iraq conflict and, consequently, this bond did not do well. When the fed started raising rates the coupon looked to us as if it was going to ratchet up nicely. What is more, defense stocks were out of favor and were cheap. The reason we decided to invest in the convertible was two-fold. First, as rates came back up suddenly we could see a strong investment grade bond paying higher and higher rates of interest. The coupon got up towards 5% at one point, which is high for effectively a short dated single A- type credit. That is an issue we would still own today except that most convertibles are callable after 3 to 5 years. The companies make use of that to force you to buy the stock if you would like to continue as an investor. It is not our philosophy to hold stocks for any extended period post conversion, so when Lockheed Martin was nearing call period; we sold it out at a profit. There have periodically been situations where we end up with some battered securities that look to be attractive on a credit basis. Recently, we increased our investment in The Pantry, Inc., a convenience store chain with gas stations. The stock had been very depressed based on poor retail gasoline margins, but the company’s balance sheet is quite healthy. We were following the company closely on our high yield desk and we were aware that there is a put option due to expire in the next few years, which was yielding doubledigit, so we thought that would be a good investment regardless of whether the stock recovered, or not. In the long run, the stock did recover. Gasoline refining and marketing margins have gotten a little better. We thought the credit was good enough to buy the put. Q:  What is your portfolio construction process? A : We have about a hundred companies in the portfolio. The number of issues can vary because some companies issue multiple convertibles, and we may hold more than one for a number of reasons ranging from liquidity at the time of purchase to trying to blend an exact amount of yield and premium. We are broadly diversified and a single position rarely gets up to as much as 3%. As we look to manage risks, we are not particularly closeted to benchmarks because the convertible market does not have a benchmark as widely accepted as the S&P 500 index. There could be differences of opinion as to how a convertible fund should perform, but one of our principal tools of considering risk is to look at our weightings in the portfolio compared to the Merrill Lynch All Convertible Index, which is similar to the Wilshire 5000 index in the stock market. What we typically look at are sector weights and what we call delta-adjusted weights, where delta is the measure of equity sensitivity. We adjust the benchmark for its equity sensitivity by sector and we adjust our portfolio for that. We also look at the percentage of our portfolio that is different credit weighting baskets. At this point, we are similar to the market, which is about half investment grade, half sub-investment grade or unrated with some of the unrated being very high quality companies that just choose not to get a rating because they may have very little debt, for instance. Q:  What are your views on risks and how do you monitor and control it? A : We are constantly monitoring our exposure to the credit and equity markets and our sensitivity to them. If we feel the outlook is positive for equities, we will be comfortable with higher delta in the portfolio. If we believe that there is a higher degree of risk in credit markets than we may lower weights to each holding, or even sell securities. Usually, because of the bottom-up nature of our portfolio, we do not end up being much better or worse in credit quality, but we do monitor that in the universe. The convertible market is a derivative market, and is bereft of the kind of derivative tools people use in other markets. We do not have the ability to hedge our index or modify the portfolio using derivatives. This can only be implemented by buying and selling individual convertible holdings. Based on common sense, we do not have large weightings in any individual holding and we look to manage equity related risks by sector. Another element we monitor but we do not actively manage is structures. All else being equal, your portfolio is more conservative if it has more bonds and less conservative if it has more convertible preferred. The mandatory structure, a convertible preferred, is the least conservative structure. You will end up owning the equity at a certain future point in time and some people put a great deal of weight on that when weighing risks.