Portfolio Adviser • October 2016 • Double Take

The NN Global Convertible Opportunities Fund invests in a concentrated portfolio to maximise equity exposure per unit of risk…

Convertible bonds can provide a mix of credit and equities that, over the longer term, have provided equity-like returns with reduced volatility.

They are corporate bonds with an additional feature: they are convertible into shares at a set price at the option of the holder. As such, they have the defensive qualities of bonds that pay par at maturity – unless the issuer defaults. Convertibles provide lower yields than comparable bonds but offer valuable equity options in return.

NN Global Convertible Opportunities invests in companies via convertibles to maximise equity exposure per unit of risk. The team applies bottom-up credit analysis within a top-down thematic process. It typically invests in a focused portfolio of between 30 and 50 convertible bonds.

Convertibles are often absent from investors’ portfolios. As such, they can act as a great diversifier, enhancing the risk/return ratio by offering a bridge between the safety of bonds and the upside of equities.

Given most developed market bonds are trading at very low or even negative yields, and equities do not look too cheap either, convertibles are a good way to make a spread while keeping traction to potential equity upside and avoiding any full-on risk.

The market is very much alive, having maintained over the past three years the $80-100bn of annual issuance it needs to refresh itself.

In the US, there are higher spreads available with new names issuing convertibles and refinancing by energy companies. In Europe, it is largely investment/higher- grade names that are issuing.

The three main drivers of returns are underlying equity returns, credit spreads and interest rate movements, and changes in valuations. Currently, the majority of returns come from underlying equities. Stock selection is therefore key.

The team uses theme-based equity selection. In the context of thematic investing, a theme works like a rising tide, benefiting all companies exposed to the theme.

High-conviction themes include: global ageing, online spending, healthcare spending, cloud computing, infrastructure spending, changing diets and consumption.

These themes are to a degree independent of the economic cycle. They occur come rain or shine, whether the US Federal Reserve hikes rates or not, and whether the Chinese economy grows at 5% or 6% per annum.

For example, in our theme online spending, we believe more business will be done online at the expense of traditional channels. Priceline is a name we like in that context. As the operator of the booking.com website it is the largest online travel agent globally. Priceline sells 100 million hotel bookings per quarter and manages to grow its sales by 25-30% per annum.

Another theme is infrastructure spending. There will be nine billion inhabitants on this planet soon, which will require a major infrastructure build-out. We invest, for instance, in Italian cable manufacturer Prysmian. This company makes high-end cables that transport energy between offshore windfarms and the mainland. More people will require more energy and more efficient transport of energy, and this tide is unlikely to stop in the near future.

‘A THEME WORKS LIKE A RISING TIDE, BENEFITING ALL COMPANIES EXPOSED TO THE THEME’

…while the M&G Global Convertibles Fund focuses on identifying issues that are mispriced by other investors

Convertibles are like other corporate bonds in that they generally pay a fixed rate of interest over a set period of time, after which they are repaid. But they also offer investors an extra feature – the right to convert the bond into a set number of shares, usually of the issuing company.

Convertibles, therefore, have the characteristics of shares and bonds. They rise when stockmarkets are going up, but hold up better in more difficult times, which is what makes the asset class attractive to investors.

Returns are asymmetric, meaning convertibles participate in more of the price moves when equities rise rather than fall.

The fund aims to maximise long-term total return by investing in an unconstrained, diversified portfolio of global convertibles. The convertibles likely to generate the most asymmetric returns are ‘balanced’ or ‘at the money’ convertibles, with equity sensitivities, or delta, in the range of 30-70%.

Convertibles with deltas above this range tend to mirror moves in the underlying equity price, offering little downside protection, while those below this range generally act like bonds, with little link to any equity upside.

Importantly, the technical characteristics of a convertible must be supported by strong company fundamentals.

A bottom-up, global approach to the selection of convertibles, along with fundamental analysis, plays a key role in identifying the best ideas. The credit quality of the issuer, the valuation of the underlying equity and the technical characteristics of the convertible must all be scrutinised.

Through this process, it is possible to identify issues that are mispriced by other investors. The approach has a long-term horizon as it takes time for the fundamental characteristics to be recognised more widely.

A portfolio should be diversified with ideas from different regions and industry sectors across the world. The typical weight of a position is about 1-2% but high-conviction investments can reach 2.5-3.5%.

Risk management plays an integral role. Constant reassessment of the potential gains and losses of individual names allows the construction of a portfolio that should deliver the best risk-adjusted returns.

Convertibles currently seem well placed to continue their good long-term performance relative to both equities and bonds, particu-larly given the prevailing fragility of investor sentiment, despite many global stockmarkets trading close to all-time highs. This should be a beneficial environment for convertibles, with their ability to participate in any further upside but provide an element of downside protection.

The convertibles market offers genuine diversification appeal and contains compelling opportunities to gain exposure to under- researched companies. I find the most interesting opportunities in the US, where the technical characteristics and credit spreads look more attractive than much of the rest of the world.

The prevalence of non-rated stocks and bonds issued by mid-cap companies in the convertibles universe is also attractive, and can reward rigorous analysis with potential re-ratings of the issuer’s equity price or credit quality.

‘ THE TYPICAL WEIGHT OF A POSITION IS ABOUT 1-2%, BUT HIGH-CONVICTION INVESTMENTS CAN REACH 2.5-3.5%’

Since the global financial crisis, the convertible bond market has shrunk and has since remained a niche area for investors seeking defensive equity exposure or to diversify bond allocation. Low interest rates mean more convertibles are issued with zero coupons, while rangebound equity markets place a cap on upside potential.

The sector, however, is full of success stories. Tesla’s convertible issued in 2013 now trades at more than 50% above its par value and still pays a coupon of 1.5%, so it is certainly a sector to keep an eye on.

Year to date, M&G Global Convertibles has had a phenomenal performance in sterling terms. It is a well-diversified portfolio of more than 100 bonds. In contrast, NN Global Convertible Opportunities is concentrated strategy, containing 25-35 bonds.

We prefer the NN fund as we like the clarity of the investment process and the fund managers’ thematic approach. One of the key themes in the portfolio is global demographics, which we believe will remain a fundamental driver of market returns in the long term.