Convertible securities funds offer the security of bonds without sacrificing upside potential in the equity market. This often overlooked asset class provides investors with a means to soften volatility over the long term. Investors with a well-balanced portfolio who are adding these securities should consider Vanguard Convertible Securities (VCVSX). The fund tracks the performance of the MSCI US Investable Market Index/Financials 25/50. This benchmark index is composed of large, midsize and small-cap companies in the U.S. financial sector. The fund adviser invests all substantial assets under management in securities held in the index.
Convertible Securities
Most simply, a convertible security is a financial instrument that can be changed into another type of investment. In the case of the convertible bond, it can be exchanged for an equity position in the company. Until it is changed into equity shares, the convertible bond will pay a periodic fixed amount of interest based on its coupon rate. The bond will have a specific price at which it can be exchanged for common shares. The coupon rate is typically lower than for a standard bond, but the conversion factor is like a call option on the common shares and rises in value if the stock price rallies. The conversion price is usually set at a price significantly higher than where the stock is trading when the bond is issued. Initially, the bond will trade like a bond, but it tends to be less volatile because a portion of the value lies in the “call option” attached to it. As the price of the stock rises and convertibility becomes possible, the performance of the underlying common shares increasingly influences the price of the convertible bond. If the price moves above the conversion price, at which point it is more profitable to convert the bonds into stock, the bond will begin trading like the stock.
Benefits of Convertible Bonds
These hybrid investments offer benefits to both equity and fixed-income investors. The structure of a convertible bond can preserve capital and reduce volatility while maintaining upside potential due to its equity-conversion component. Over the past 15 years, convertible bonds have participated in approximately two-thirds of the market upside while being subject to only one-third of the downside, based on a rolling three-year period. Lower volatility is especially important for retirees who may be drawing on their assets. Convertibles have benefited from the equity market strength in recent years.
When compared with the passively indexed Vanguard 500 (VFIAX), VCVSX has lagged VFIAX over the past 3- and 5-year periods. However, with an annualized return of 6.12 percent over the past 15 years, VCVSX beat the 5.04 percent return delivered by VFIAX over the same period, with much lower volatility. VCVSX has a three-year trailing standard deviation of 7.3 versus 11.0 for VFIAX.
Investment Strategy
VCVSX is advised by Oaktree, which has a long history of investing in niche debt markets, including convertibles. Fund managers use a fundamental bottom-up analysis with an eye toward value when selecting individual securities, which are evaluated based on their structure and terms. Other criteria include the capital structure of the issuing company and its credit rating. Managers also consider the underlying fundamentals of the stock and its potential for capital appreciation. Managers focus primarily on convertible bonds, with slight exposure to convertible preferred stock. The fund does not buy traditional debt or equity positions. This creates a portfolio of convertibles that offer an equal balance of bond and equity characteristics. Managers prefer to stay fully invested and rarely hold a sizable cash position. The current 5.9-year average duration is within the five- to seven-year target range. The management team assigns a credit rating to each security. Based on this standard, the managers give their fund an average quality rating of BB.
Stu Spangler has overseen the domestic sleeve, which accounts for 70 percent of AUM, since June 2015. Like the U.S. convertibles market in general, the portfolio is concentrated in health care and technology issues. The fund also has significant exposure to the financial sector. While the remainder of the portfolio is broadly invested across other market sectors, managers have reduced the fund’s exposure to energy-related convertibles. Because they lost their balanced characteristics, many energy-related securities were[KRQ1] no longer attractive. The remaining energy exposure is issued by companies that management believes can withstand the current turmoil in the oil and gas space. Top holdings include convertibles issued by Priceline (PCLN), Red Hat (RHT), Salesforce.com (CRM) and LinkedIn (LNKD).
The fund’s overall performance in recent years has been impacted by a 30 percent increase in exposure to a foreign convertibles sleeve. This European market has underperformed its U.S. counterpart, which has detracted from the fund’s returns. The foreign sleeve, led by Abe Ofer and Jean-Paul Nedelec, can be an attractive feature as it adds to the fund’s diversification and possible long-term prospects. Both managers are founding members of Oaktree and have more than 20 years of experience investing in convertibles. Foreign convertibles tend to be of higher quality and are issued by larger companies than in the U.S., and foreign currency exposure to the U.S. dollar is hedged.
Expenses
VCVSX features a low 0.38 percent expense ratio. In addition to being the least expensive open-end fund, VCVSX is also less expensive than most convertible exchange-traded funds. Long-term investors looking to diversify a portfolio by adding an exposure to convertible bonds should consider VCVSX, which has a four-star rating from Morningstar. The fund has a minimum initial investment of $3,000.
Outlook
Like other credit-oriented markets, convertibles have recently faced selling pressure. The balanced approach followed by VCVSX has enabled it to fare better than most of its peers. At the end of February 2016, the fund’s 4.55 percent loss is less than the average negative 6.08 percent return in the open-end convertibles category. It also performed better than the category’s underlying index.
While the fund is less volatile than a pure stock fund, it does have risk: though much less than the broader market, VCVSX fell nearly 30 percent in 2008. Investors who are averse to equity risk should stick with traditional bonds. The fund is a good fit for investors looking to dial back some of the volatility in their portfolio without giving up all of the upside gains from equities. With a yield of 2.07 percent, VCVSX also won’t sacrifice income for investors switching from a passive index fund such as VFIAX, which currently yields 2.26 percent.
We currently recommend VCVSX as a Strong Buy with a rank of 83. Should you have questions concerning the suitability of this fund, please call us at (888) 252-5372.
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