Convertible bond investing Invesco s Convertible Securities Strategy

Transcription

1 1 Convertible bond investing Invesco s Convertible Securities Strategy

2 Introduction to convertible bonds A primer Convertible securities provide investors the opportunity to participate in the upside of stock markets while also offering potential downside protection. Because convertibles possess both stock- and bond-like attributes, they may be particularly useful in minimizing risk in a portfolio. The following is an introduction to convertibles, how they exhibit characteristics of both stocks and bonds, and where convertibles may fit in a diversified portfolio. Reasons for investing in convertibles Through their combination of stock and bond characteristics, convertibles may offer the following potential advantages over traditional stock and bond instruments: Yield advantage over stocks More exposure to market gains than market losses Historically attractive risk-adjusted returns Better risk-return profile Lower interest rate risk Introduction to convertibles A convertible bond is a corporate bond that has the added feature of being convertible into a fixed number of shares of common stock. As a hybrid security, convertibles have the potential to offer equity-like returns due to their stock component with potentially less volatility due to their bond-like features. Convertibles are also higher in the capital structure than common stock, which means that companies must fulfill their obligations to convertible bondholders before stockholders. It is important to note that convertibles are subject to interest rate and credit risks that are applicable to traditional bonds. Simplified convertible structure Bond Source: BofA Merrill Lynch Convertible Research. Call option Convertible The bond feature of these securities comes from their stated interest rate and claim to principal. Like any fixed income instrument, the bond s value depends on its creditworthiness, yield and time to maturity. The stock feature is derived from the embedded call option that allows the convertible bond to participate in stock appreciation. As such, the option value is tied to factors affecting the underlying stock price. Factors that affect the embedded option include stock price movement and the amount of time left on the option. As market movements increase, the probability that the underlying stock price will appreciate also increases, which results in a higher value assigned to the option portion of the convertible bond. The longer the amount of time left on the option, the higher its value. Data as of Dec. 31, 2016, unless otherwise stated. 1

3 Exhibiting stock- and bond-like behavior Convertible bonds exhibit the characteristics of both stocks and bonds. Among convertibles, there s a spectrum. At issuance, the bond is typically a balanced, total return convertible that has a favorable upside/ downside profile. Balanced convertibles are typically characterized by moderate yields, stock price sensitivity and conversion premiums the percentage by which the bond price exceeds the value of the underlying stock or parity (stock price x number of shares into which the bond converts). This type of convertible is illustrated in the center of the chart below. If the underlying stock moves higher, the convertible exhibits more stock-like characteristics, including lower yields, greater stock price sensitivity, and lower conversion premiums. This in the money convertible is illustrated in the right-hand section of the chart below. On the other end of the spectrum, if the underlying stock sells off, the convertible should exhibit more bondlike characteristics, have a higher yield and conversion premium, and have less downside risk than the common stock. This out of the money convertible is illustrated in the left-hand section of the chart below. Convertibles characteristics change when the price of the underlying stock rises or falls Conversion premium Convertible price curve Convertible price Delta < 0.40 Parity Investment value Delta > 0.80 Stock price Yield instrument Total return instrument Equity alternative Source: BofA Merrill Lynch Convertible Research. For illustrative purposes only The balanced bond/total return part of the spectrum may be considered the sweet spot of convertible investing. Here convertibles historically demonstrate less risk relative to their common stocks that is, they have typically participated in a greater portion of the underlying stock s upside than its downside. Moreover, downside participation is limited given the convertible s fixed income attributes an income stream in the form of a regular coupon or dividend along with repayment of principal at maturity or in the event of a put or call (unless the issuer has defaulted or entered bankruptcy proceedings). In the chart above, those bond-like instruments would likely be more credit sensitive, whereas stock-like instruments would tend to fluctuate more with the price of the underlying stock. Definitions of convertible terminology Investment value: The value of the convertible bond if it were simply a traditional bond without a conversion feature. Acts as the bond floor. Parity: Also known as the conversion value, this is the stock s current price times the predetermined number of shares for which the convertible bond may be converted. This set number of shares is also referred to as the conversion ratio. Conversion premium: In the chart above, it is represented by the shaded area. It is the amount by which the convertible bond price exceeds parity (the conversion value). It is expressed as a percentage. Delta: A measure of the convertible bond s price sensitivity to underlying stock price movements. Convertible bond investing through Invesco s Convertible Securities Strategy 2

4 Five reasons for investing in convertibles 1. Yield advantage over stocks Convertibles have historically provided a yield advantage over equities. As of Dec. 31, 2016, the US convertibles market, as measured by the Bank of America Merrill Lynch US Convertible Index, had an average yield of 3.15%, 1 representing a 170 basis point advantage over its underlying equities. In addition, convertibles are senior to equities in the capital structure. 2. Potentially more exposure to market gains than market losses Over various market cycles, convertibles have historically captured more of the equity market s upside due to their embedded call option, while providing a measure of downside protection due to their bond-like characteristics. Convertibles performance During bull, bear, recovery and full market cycles BofA Merrill Lynch US Convertible Index S&P 500 Index NASDAQ Composite Index Russell 2000 Index Annualized return (%) Bull market 10/02-9/07 Bear market 10/07-2/09 Recovery 3/09-12/16 Full market cycle 10/02-12/ Source: StyleADVISOR, Zephyr. As of Dec. 31, Past performance cannot guarantee future results. Index returns do not reflect any fees, expenses or sales charges. An investment cannot be made in an index Historically attractive risk-adjusted returns Convertibles have historically outperformed equities over various time periods with substantially less volatility, offering an attractive risk-reward profile versus equities. One way of measuring a risk profile is using beta, which measures the magnitude of share price fluctuations in relation to a specified index. Versus equity indexes such as the S&P 500 Index, NASDAQ Composite and Russell 2000 Index, convertibles exhibit a lower beta over various time periods. Less risk vs. equities As measured by beta 2 1 year 3 3 years 5 years 10 years 15 years BofA Merrill Lynch US Convertible Index S&P 500 Index NASDAQ Composite Index Russell 2000 Index Source: Zephyr, StyleADVISOR, Lipper Inc. As of Dec. 31, Past performance cannot guarantee future results. An investment cannot be made in an index. 1 Source: BofA Merrill Lynch 2 Beta values shown are for the indexes versus the Russell 2000 Index. 3 Beta for 1 Year was calculated on a daily basis. 3

5 Looking back, convertibles have exhibited comparable behavior to either common stock or bonds over complete market cycles. The chart on the following page shows cumulative total annual returns going back to 1980 for stocks, convertibles and bonds. Since 1980, convertibles have outperformed bonds while participating in the equity market s upside Cumulative total returns since 1980 BofA Merrill Lynch US Convertible Index S&P 500 Index BofA Merrill Lynch High Yield Master Index BofA Merrill Lynch Corp./Gov t. Master Index Percent (%) ,000 5,588 5,000 4,000 3,000 2,000 1,000 3,865 2,658 1,488 0 Source: -500 Bank of America/Merrill Lynch Convertibles Research, as of Dec. 31, Past performance cannot guarantee future results. Index returns do not reflect any fees, expenses or sales charges. An investment cannot be made in an index. 4. Better risk-return profile Convertibles may improve the risk-return profile of multi-asset class portfolios. Historically, adding convertibles to a bond portfolio has pushed out the efficient frontier, in other words, creating a portfolio that achieved a higher return with the same level of risk. The inclusion of convertibles to a portfolio of government and corporate bonds can potentially provide investors more return for the same amount of risk when compared to a traditional stock and bond portfolio. Improved risk-return profile (January December 2016) Portfolio of bonds and convertibles Return (%) Portfolio of traditional stocks and bonds 100% converts 100% equities 13 25% bonds, 75% converts 85% equities, 15% bonds % converts, 50% bonds 50% equities, 50% bonds 70% equities, 30% bonds % bonds Risk (%) Source: BofA Merrill Lynch, Invesco from January 2009 through December Past performance cannot guarantee future results. An investment cannot be made in an index. Each point on the line represents a blended portfolio of either stocks & bonds or convertibles & bonds. The data points begin with a 100% bond portfolio, and then the mix changes by increments of 5% until it reaches 100% equities or convertibles. For instance, the 2nd point represents 95% bonds, 5% equities (or convertibles) whereas the 2nd to last point represents 5% bonds and 95% stocks (or convertibles.) Risk is measured by standard deviation. Standard deviation measures a fund s range of total returns and identifies the spread of a fund s short-term fluctuations. Stocks are represented by the S&P 500 Index. Bonds are represented by the BofA Merrill Lynch Corporate/ Government Master Index. Convertibles are represented by the BofA Merrill Lynch US Convertible Index. Convertible bond investing through Invesco s Convertible Securities Strategy 4

6 5. Lower interest rate risk Due to their put/call features, convertibles tend to have shorter durations than their traditional fixed income counterparts. With rates near their all-time lows, some investors are concerned about the impending impact of rising interest rates. While convertibles are influenced to a degree by interest-rate fluctuations, they are also impacted by the price movements of their underlying stocks, a factor that has tended to soften the negative effect of rising interest rates. The average duration of the convertibles market is is less than three years, compared to 4.14 to 5.81 years for the corporate high yield and aggregate bond markets, respectively. 1 The data below shows the performance of stocks, bonds and convertibles over the past 26 years when the 10-year Treasury yield rose more than 120 basis points. Convertibles have offered attractive returns in rising interest rate environments 12/21/89-5/2/90 10/15/93 11/7/94 1/18/96 7/5/96 10/5/98 1/20/00 11/7/01 4/1/02 6/13/03 6/14/04 6/2/05-6/26/06 12/18/08-6/10/09 10/6/10-2/8/11 7/25/12-2/31/13 8/7/16-5/12/16 10-year Treasury yield increase (bps) BofA Merrill Lynch US Convertible Index(%) S&P 500 Index (%) Barclays U.S. Government Credit Index (%) Sources: Bloomberg L.P., StyleADVISOR. Data as of Dec. 31, A basis point is the movement of interest rates or yields expressed in hundredths of a point. Past performance cannot guarantee future results. Index returns do not reflect any fees, expenses or sales charges. An investment cannot be made directly in an index. Convertibles as part of a diversified portfolio There are different ways you can use convertibles to pursue your asset allocation goals. Convertibles may be considered a defensive stock approach that could mitigate the need to time the market because of the potential to participate in the upside of the equity markets while also potentially having an element of downside preservation. In addition, as stated earlier, convertibles have historically had a yield advantage over their underlying stocks. We believe over the long term, convertibles can be used as a separate and distinct asset class due to their historical risk-reward profile and low correlation with fixed income securities, and high, but imperfect, correlation with equities. Convertibles have a low correlation to traditional asset classes BofA ML US Convertible Index BofA ML US Convertible Index 1.00 Russell 2000 Index NASDAQ Composite Index Barclays U.S Government/ Credit Index S&P 500 Index Russell 2000 Index NASDAQ Composite Index Barclays U.S. Government/ Credit Index S&P 500 Index Source: StyleADVISOR. Period covers January 1990 to December Correlation indicates the degree to which two investments have historically moved in the same direction and magnitude. Investments cannot be made directly into an index and past performance is not a guarantee of future results. 1 Source: Barclays. Data as of Dec. 31, 2016, as measured by the Barclays U.S. Corporate High Yield Index and Barclays U.S. Aggregate Index, respectively. The average convertible market duration is based on data for the BofA Merrill Lynch US Convertible Index. An investment cannot be made in an index. For index definitions, see the last page. 5

7 Within stock allocations, if you wish to be a little more defensive and to pick up some yield, convertibles may be appropriate. You would focus on the balanced/total return part of the convertibles spectrum. For bond allocations, convertibles may be appropriate if you are looking to add stock exposure. You can potentially add alpha by sacrificing a certain amount of yield to obtain some stock exposure. For this you would focus on the bond instruments and/or the balanced bond/total return parts of the convertibles spectrum. In addition, if you are overweight bonds and concerned that interest rates are going to rise, convertible bonds may make sense. Rather than allocate out of bonds and into stocks, you can allocate to convertibles and have the potential to participate in stock-like returns at a lower risk level. Invesco s Convertible Securities Team Investment philosophy and process We believe that by constructing a well-diversified portfolio, strong long-term performance may be achieved with lower risk. We focus on traditional convertibles that offer a balanced risk-reward profile. We seek wellmanaged companies with strong balance sheets, a clear business focus and competitive advantages versus their peers. We first look for growth potential and reasonable valuations, and then develop an investment thesis for each issue. In constructing the portfolio, we use a barbell approach and aim to target the equity sensitivity, or delta, of the portfolio based on market conditions. Factors such as the macroeconomic environment and specific industry fundamentals are continuously monitored, and ongoing equity/credit analysis is consistently performed. Issues are re-evaluated when our investment thesis changes or a security s price falls more than 10%. Our strong emphasis on risk management is key to our discipline; we believe managing through the cycles is a better long-term strategy than managing to the cycles. Diversification does not guarantee profit or eliminate the risk of loss. Seasoned and experienced team The team is solely dedicated to the convertible securities asset class, and are one of the most tenured and stable teams in the space. Ellen Gold has been a member of the Invesco Convertibles Team since 1989 and its lead portfolio manager since Ramez Nashed joined the team in 2000 and has been a portfolio manager on the team since Senior analyst Stuart Novick joined the team in 2014, and has over 25 years of experience in the convertible securities market. Differentiators of Invesco s Convertible Securities Strategy Although the strategy may invest in synthetics, we do not and have not invested in them in the past. We believe synthetics expose investors to additional risk, including counterparty risk, liquidity risk and limited transparency. In addition, the team does not buy equities, although they may hold them out of conversions nor do we buy non-convertible debt issues. The team focuses on traditional convertibles that offer a balanced risk-reward profile. The team looks for securities with reasonable valuations that show potential for strong total return through interest and dividends, coupled with the upside potential of the embedded option. We believe that this strategy allows us to manage through the cycles, not to the cycles, potentially achieving better long-term risk-adjusted performance. The team will barbell the portfolio using busted/credit-sensitive issues and equity-like convertibles to control the portfolio s equity sensitivity, or delta. The team attempts to mitigate concentration risk by maintaining an average position size of approximately 1.0%. Our top 10 holdings typically represent less than 15% of the portfolio. Available vehicles Mutual fund Institutional separate account $50 million minimum Convertible bond investing through Invesco s Convertible Securities Strategy 6

8 Explore High-Conviction Investing with Invesco At Invesco, we re dedicated to delivering an investment experience that helps you get more out of life. Ou comprehensive range of high-conviction investment capabilities is designed to help you build portfolios in more precise and impactful ways, and not just settle for average. This high-conviction approach is built on three core tenets: A pure focus on investing All we do is investment management. That means we are solely focused on delivering high-conviction portfolio solutions to meet your unique needs. Diversity of thought Passion to exceed Each of our investment teams is empowered to implement its own trusted investment philosophy and process. Our diverse range of capabilities allows you to create high-conviction portfolios custom-built for your needs. We are passionate about going beyond average to uncover high-conviction opportunities and provide an exceptional client experience. About risk Convertible securities are subject to the risks associated with both fixed-income securities and common stocks. To the extent that a convertible security s investment value is greater than its conversion value, its price will be likely to increase when interest rates fall and decrease when interest rates rise, as with a fixed-income security. If the conversion value exceeds the investment value, the price of the convertible security will tend to fluctuate directly with the price of the underlying equity security. Convertible securities may be subject to risk of an issuer of a convertible security exercising the right to call the issue, forcing investors to convert their securities into the predetermined number of shares. The strategy may own convertible securities, the value of which may be affected by market interest rates, the risk that the issuer will default, the value of the underlying stock or the right of the issuer to buy back the convertible securities. The issuer of instruments in which the strategy invests may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer s credit rating. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise; conversely, bond prices generally rise as interest rates fall. Specific bonds differ in their sensitivity to changes in interest rates depending on their individual characteristics, including duration. The strategy s foreign investments may be affected by changes in a foreign country s exchange rates, political and social instability, changes in economic or taxation policies, difficulties when enforcing obligations, decreased liquidity, and increased volatility. Foreign companies may be subject to less regulation resulting in less publicly available information about the companies. Junk bonds involve a greater risk of default or price changes due to changes in the credit quality of the issuer. The values of junk bonds fluctuate more than those of high-quality bonds in response to company, political, regulatory or economic developments. Values of junk bonds can decline significantly over short periods of time. The strategy may hold illiquid securities that it is unable to sell at the preferred time or price and could lose its entire investment in such securities. In general, stock and other equity securities values fluctuate in response to activities specific to the company as well as general market, economic and political conditions. Invesco Distributors, Inc., is the US distributor for Invesco Ltd. s Retail Products. Invesco Advisers, Inc. provides investment advisory services and does not sell securities. Both firms are indirect, wholly owned subsidiaries of Invesco Ltd. Past performance cannot guarantee future results. An investment cannot be made directly in an index. Asset allocation/diversification does not guarantee a profit or eliminate the risk of loss. The opinions expressed by portfolio managers in this article are based on current market conditions as of Dec. 31, 2016, and are subject to change at any time based on market or other conditions and offer no guarantee of future positive performance for any strategy or security mentioned. These opinions may differ from those of other Invesco investment professionals. This article is provided for educational and informational purposes only and is not an offer of investment advice or financial products. In addition, the results actual investors might have achieved may vary from those shown. The S&P 500 Index is generally representative of the US stock market. The Barclays U.S. Government/Credit Index includes Treasuries and agencies that represent the government portion of the index, and it includes publicly issued US corporate and foreign debentures and secured notes that meet specified maturity, liquidity, and quality requirements to represent the credit interests. The BofA Merrill Lynch US Convertible Index is a market-capitalization weighted index of domestic corporate convertible securities. In order to be included in the index, bonds and preferred stocks must be convertible only to common stock and have a market value or original par value of at least $50 million. The NASDAQ Composite Index is a broad-based capitalization-weighted index of all NASDAQ National Market & Small Cap stocks. The Russell 2000 Index is an unmanaged index considered representative of small-cap stocks. The Russell 2000 Index is a trade-mark/ service mark of the Frank Russell Co. Russell is a trademark of the Frank Russell Co. BofA Merrill Lynch High Yield Master Index tracks the performance of below investment grade US dollar-denominated corporate bonds publicly issued in the US domestic market. The BofA Merrill Lynch Corporate/Government Index tracks the performance of US dollar denominated investment grade debt publicly issued in the US domestic market, including US Treasury, US agency, foreign government, supranational and corporate securities. The Barclays U.S. Corporate High Yield Index is an unmanaged index that covers the universe of fixed-rate, noninvestment-grade debt. The Barclays U.S. Aggregate Index is an unmanaged index considered representative of the U.S. investment-grade, fixed-rate bond market. An investment cannot be made directly in an index. Standard deviation measures a fund s range of total returns and identifies the spread of a fund s short-term fluctuations. Counterparty risk is the risk to each party of a contract that the counterparty will not live up to its contractual obligations. Liquidity risk is the risk that stems from the lack of marketability of an investment that cannot be bought or sold quickly enough to prevent or minimize a loss. Limited transparency is the extent to which investors have limited access to any required financial information about a company, such as price levels, market depth and audited financial reports. CLCSEC-BRO-1 03/17 Invesco Distributors, Inc. Invesco Advisers, Inc. US2263