CEF Insights: Convertible Securities Benefits And Opportunities In Today's Challenging Market

CEFA: Welcome to CEF Insights, your source for closed-end fund information and education, brought to you by the Closed-End Fund Association. Today, we are joined by Barry Nelson, Partner and Senior Advisor with Advent Capital Management. Advent manages the Advent Convertible and Income Fund, ticker AVK.

We're happy to have you with us today, Barry.

Barry Nelson: Well, it's certainly an honor to be here. Nothing pleases me more than explaining my favorite asset class, convertible securities.

CEFA: Barry, Advent has particular expertise in managing convertible securities. What are the key characteristics of convertible securities, and how can this benefit investors?

Barry Nelson: The key characteristic of convertibles can be said in two words, positive asymmetry. On the downside, risk is muted because we are investing in bonds that mature at par. But on the upside, the fact that our convertibles can be converted into a fixed number of common shares provides upside if the underlying stock rises. This is a tremendous way to participate in the stock market at much less risk than in common stocks.

Indeed, on May 8th, The Wall Street Journal had an article headlined “Investors Seek Safety but Want Piece of a Rally”. Convertibles are a good way to participate when equities perform as they will over the long-term, assuming less risk than outright investment in common stocks.

CEFA: How diverse is the universe of issuers in the convertible space with regard to industry sector? Are you seeing new issuers come into the market?

Barry Nelson: Diversification is an ongoing factor with convertible securities. Historically, really the only concentration has been in growth companies, notably in tech companies and healthcare, companies that over time have performed very well. In fact, if you look at the 25 largest companies in the United States, 20 of them have at one time issued convertibles. The most successful companies, almost all of them, have issued convertibles.

Lately this year, new issuance has dramatically recovered after a slow point last year. Notably, we're seeing more utilities in the market, and it's possible that with the emphasis on electrification of motor vehicles that utilities are becoming growth companies. We're also seeing a slight trend toward higher quality. Something like 25% of the global convertible market now is rated investment grade.

CEFA: I mentioned earlier that Advent manages a closed end fund, Advent Convertible and Income Fund, symbol AVK. The fund allocates to convertibles and high-yield securities. How are these asset classes complimentary to each other?

Barry Nelson: A key way they're complementary is that they tend to represent different industries. The convertible market historically has been dominated by tech, and it's been relatively light on energy. This is the reverse of the high-yield market. Indeed, I would say that high-yield issuers tend to be less growthy than convertible issuers, so that mixing the two together in one fund is a great way to create a lot of diversification within the portfolio.

CEFA: How does the fund allocate between convertibles and high-yield, and what would bring about a significant shift in the allocation?

Barry Nelson: We are always assessing the macroeconomic environment and looking for optimal allocation, and we do tilt back and forth, but we do so in a calm way. In the last three years, the balance between convertibles and high-yield has been approximately 45 to 60% convertibles and 30 to 45% high-yield. Factors that will influence us are the relative yields of these securities and our concerns or optimism about the stock market and similarly, concerns or optimism about the credit spreads on the high-yield securities.

CEFA: Advent is an active manager. How important is active management to performance of a portfolio like AVK?

Barry Nelson: Active management of convertibles enables the portfolio managers to focus on the convertibles that are most likely to capture the upside if the underlying stocks move up. That is an emphasis on issues where the conversion value is somewhere close to par and where the convertibles are going to respond quickly on the upside.

This contrasts with, for example, ETFs that buy essentially every security in a provided index, and that would range from some convertibles that are essentially pure yield instruments to some where the underlying stocks have pushed them so high that they're almost the equivalent of common stocks and no longer provide the asymmetry that is the key attraction of convertible securities.

CEFA: Barry, the Federal Reserve has been aggressively raising interest rates. Inflation has been high and economic growth has slowed. We also have significant geopolitical tensions, as well as some issues in the banking sector that have added to volatility. Where do you see the investment markets currently, and what is your outlook for the rest of 2023?

Barry Nelson: We're cautious about the economy because the effects of rising rates engineered by the Federal Reserve usually lag over time. Consequently, we probably haven't seen the most serious effects, and we think this plays well to our traditional emphasis on credit quality as a driver of both our convertible investments and our high-yield investments.

CEFA: What challenges does this environment present to income-oriented investors?

Barry Nelson: Well, the big risks for income-oriented investors are that interest rates will continue to rise, and this tends to knock down the prices of straight fixed income investments. Although most sharply, it knocks down Treasuries as opposed to high-yield. With convertibles, any damage from rising rates should be muted by the fact that the durations of our convertible securities are relatively short, probably under three years in the portfolio, and that reduces our direct sensitivity to changes in the interest rates on Treasury securities.

CEFA: How does this position convertible securities in the current market?

Barry Nelson: Well, it makes convertibles just a well-positioned choice to participate in what could be a resumed bull market, and yet with limited downside risk. Again, we have short durations. Our convertibles are almost exclusively bonds. There's limited downside. But if anything goes right in the stock market, we are going to participate. Many of the stocks underlying convertibles, notably technology stocks, seem to already reflect a recession scenario that suggests significant upside potential.

CEFA: Are you finding valuations in convertibles to be at attractive levels in this market?

Barry Nelson: Definitely. The convertible market generally offers attractive valuation somewhere, and we're in the market every day looking for opportunities. We intend to maintain a portfolio where we will have income and liquidity to be able to maintain the steady monthly distributions.

CEFA: Barry, where are you seeing the best opportunities in convertible securities?

Barry Nelson: We believe the best opportunities right now are both in the traditional balanced issues and in some issues that are trading at discounts that are providing yields that are competitive with high yield. These issues are out of the money. They don't have a direct mechanical sensitivity to the upside of the underlying common stocks, but they are likely to respond favorably if credit spreads contract, particularly credit spreads on individual issues. Again, our research in credit should help us select such issues.

CEFA: Barry, how do you see an allocation to convertibles best positioned in an investor's diversified portfolio and likewise for an investor that is more income oriented?

Barry Nelson: Convertibles, again, they are a way to limit the downside risk. While all history shows that over time convertibles provide equity-like returns, that is returns superior to straight traditional fixed income instruments. Somebody like me, I'm prejudiced. I would put a lot into convertible securities. I've been on Wall Street 51 years. I've been involved in equities, high-yield bonds, multiple funds, and convertible securities are my favorite asset class.

CEFA: Barry, thank you so much for taking the time to join us today.

Barry Nelson: It's always a pleasure. As I began, I said, nothing pleases me more than to explain convertible securities to investors.

CEFA: We want to thank you for tuning in to another CEF Insights Podcast.