As a steady economic recovery pushed equity securities higher in 2013, convertible securities also benefited. A convertible security is a bond that also carries the right to buy the stock of the issuing firm once it hits a certain (conversion) price. As a result, convertibles funds tend to provide much, but not all, of equities' upside with less of their downside risk. For example, last year, SPDR S&P 500 (SPY) gained 32%, the typical open-end convertible fund gained nearly 22%, and the typical convertibles closed-end fund gained nearly 20%. In an equity bear market, convertible securities should provide some downside protection--in 2008, SPY dropped nearly 37%, but the typical open-end convertibles fund lost 26% and the typical CEF lost 34%. Note that two thirds of convertibles CEFs use leverage, which can boost returns and exacerbate losses. The average leverage ratio stood at 32% at the end of 2013.
Differences in performance tend to be driven by the varying degrees of equity sensitivity within each portfolio. Funds that err on the side of conservatism, favoring securities with more bondlike characteristics, tend to fall behind in equity market rallies; those skewing more equitylike in their holdings tend to do better. The opposite is true when the equity markets perform poorly.
Some funds can hold common stock outright, though equity holdings are typically a byproduct of forced conversions to common shares. Each fund has its own set of guidelines around selling converted equity securities, which means allocation to common shares can vary widely among funds. Within the universe of CEFs, many funds also hold high-yield bonds, which add income-generation potential but are also highly correlated to movements in the equity market. For more on the basics of the convertibles market, refer to this article.
2013 in Review
During 2013, most convertible CEFs kept their allocations to corporate bonds (generally high yield), convertible securities (including synthetic convertibles), and equities relatively stable, but a few made some significant changes. During the second half of the year, Calamos upped its convertibles exposure (at the expense of corporate bonds) in both of its funds, Calamos Convertible & High Income (CHY) and Calamos Convertible Opportunities & Income (CHI), to nearly 60% by year-end 2013 from under 40%. Advent Claymore Convertibles Securities & Income I (AVK) and Advent Claymore Convertibles Securities & Income II (AGC) boosted equity exposure from 2% at midyear to about 15% by the end of 2013. To be sure, in a year where equity conversions were not uncommon, some of the added exposure is likely due to the funds simply not selling converted securities; however, both funds' overall exposure to convertible securities remained static over the year, while bond allocations dropped.
Despite strong performance, the convertibles market faced challenges in 2013. During the year, the $48 billion in new issuance nearly matched the sum of retired convertible securities, leaving the overall size of the market unchanged. The new-issue market, though gaining strength, remains hampered by the low cost of financing and strong demand in the junk-bond market. Many firms are reluctant to issue bonds with the potential for equity dilution because rates and terms in the high-yield new-issue market remain favorable to issuers. This pattern is likely to continue until long-term interest rates increase enough to steer issuers back to the convertibles market.
In general, the best-performing funds last year were those invested more heavily in equities and those favoring high-yield bonds. Advent Claymore Convertibles Securities & Income I and II, which each closed the year with about 15% in common stock, gained 22% on net asset value last year. These funds were also the most highly leveraged throughout the year. Allianz's convertibles funds, AllianzGI Convertible & Income (NCV) and AllianzGI Convertible & Income II (NCZ), each gained 24%, partly due a more-aggressive portfolio that favors equitylike convertibles as well as a historically larger-than-average tilt toward junk bonds. More-conservative funds, such as the unleveraged Putnam High Income Securities (PCF), which held essentially no equities and fewer high-yield bonds than most peers, struggled to keep pace.
The table lists the nine CEFs in the convertibles category. If applicable, a fund's Morningstar Analyst Rating is listed, along with discount, distribution, leverage, and return data, ranked by best three-year total NAV return.
There are many choices for income-hungry investors, and convertibles can be beneficial, especially in the current uncertain interest-rate environment. With the ability to tap into some of the equity market's upside potential and have protection on the downside, convertibles funds offer a middle ground. Keep in mind that because CEFs use leverage and tend to hold high-yield bonds, downside protection is limited, but over the long term, the leveraged CEFs produced compelling results. All told, convertibles funds can be a worthwhile choice for investors seeking the income of a bond while maintaining exposure to some upside potential of the underlying stock. Given the typically wide range of outcomes for this group of funds, it's important to distinguish among the options when considering an allocation to any single fund.
Cara Esser does not own shares in any of the securities mentioned above.