As the bond markets improve, and equities makes attempts to rise, convertible securities hold an interesting and potentially attractive position within the capital structure of speculative companies.

Among the convertible securities funds, we like Vanguard Convertible fund the best (symbol VCVSX).  Unlike most other types of bonds, there are no ETF products for convertible bonds, although there are some preferred securities CEF products. We have no current opinion about the CEFs, except to say that generally we prefer mutual funds or ETFs over CEFs.

VCVSX versus convertible CEFs:

Those convertible CEFs with over $100 million of assets and 5 years or more of history are: JQC, NCV, AVK, CHY, and CHI. Here is how their recent performance compares to VCVSX (shown in solid black line).

Convertible Funds versus Other Bond Fund Types and the S&P 500:

We prefer VCVSX for convertible bond (and some preferred) exposure.  Here is how that fund compares to other types of bond funds and the S&P 500 in terms of yield, credit quality and duration.

click image to enlarge

Type, Yield, Credit Quality, Duration, ETF Alternative

Credit Rating Agency Scales

VCVSX is rated Ba2 (speculative grade, below investment grade, “junk”)

Chart Comparisons – Types of Bond Funds:

Bond ETFs have a relatively short history.  The chart that follows compares the Vanguard Convertible fund (VCVSX) to an intermediate Treasuries fund (IEF), an investment grade corporate bond fund (LQD), a high yield bond fund (HYG), and a national municipal bond fund (MUB).

The convertible bond fund has experienced the deepest drop in value over the past 18 months, and has recovered less than the high yield (junk) fund.  That is either a warning sign or a remaining opportunity to buy depressed bonds before spreads improve.

Chart Comparisons – S&P 500 versus Aggregate US Bonds versus Convertibles:

We use VBMFX for Barclay’s Aggregate US Bonds (alternatives: AGG, BND), and VFINX for the S&P 500 (alternatives: SPY, IVV) in these charts.

19 Years

10 Years

5 Years

1 Year

3 Months

Management:

VCVSX is managed for Vanguard by OakTree Capital Management and a dedicated, convertibles-only team overseeing about $7 billion of convertibles.  VCVSX has about $700 million of assets. Larry Keele is the portfolio manager.

Portfolio Composition:

The average coupon is 2.5%, but the SEC yield is 4.95% (below par market valuation – no net conversion premium).  Portfolio turnover is 78% per year.  Holdings are 7.3% convertible stocks, 84.1% convertible bonds, and 8.6% cash reserves.

Credit quality spans Moody’s “Aa” (investment grade) to less than “B” (worse than “junk”) with nearly 36% “not rated”, with a net “Ba2″ average quality (middle “junk”).

click to enlarge

The top ten positions account for 27% of assets.

Returns and Expenses:

The fund is actively managed, and therefore does not have the bare bones expense ratio of an index fund, but the ratio is still moderate at 77 basis points.

Returns through 11/30/2008 have been:

• 1-year: -34.81%
• 3-years: -5.37%
• 5-years: -0.67%
• 10-years: +4.42%
• since inception (6/17/1986): 6.79%

Why Not Just Buy High Yield Equities?

We may be at or near an historic opportunity to purchase equity assets at bargain prices. If you are certain of that, then high yield equities may make better sense.  We are still tentative on equity recovery and will likely remain so until after January.

The  “get paid while you wait” argument can be made with beaten down equities, but the risk of value falling (even permanent loss) is greater with equities than with bonds.  The higher in the capital structure you are, the lower the risk of permanent loss you have for any given issuer.

US Treasuries are at the top of the global capital structure, and are being flooded with Dollars.  The result is historically low yield and possibly significant risk of capital losses as eventual market recovery causes assets to be reallocated out of Treasuries into higher risk / higher potential return assets (both bonds and stocks).

Also, until the “E” in “P/E” becomes more believable and stops being revised down, and until the “G” in “PEG” becomes more believable and stops being revised down for both companies and countries, it is hard to say which equities are really cheap and which are really expensive.

Therefore, we prefer to be higher in the capital structure until more of the smoke clears.  Convertibles are a bit higher than equities, although generally below traditional bonds, and certainly lower in the national capital structure than Treasuries and municipals.

We have been stepping into municipals, investment grade corporate bonds, preferred stocks, inflation protected Treasuries (see TIPS article), and a little bit of high yield (below investment grade) bonds.

Conclusion:

We think the history of the convertible class, and VCVSX in specific, and the transitional condition of the bond and stock markets, support including convertible exposure in small amounts for those accounts which are suitable for inclusion of speculative (”junk”) assets.

Being paid more than twice the treasury rate, and about the same as the overall bond market rate, to wait for a possible capital gain from a future conversion premium seems to us to be a more conservative form of speculation than taking a direct equity position.

Since the yield on convertibles such as VCVSX is more than 1/2 of the long-term total return on stocks, we are comfortable with the long view for 1% to 5% of assets within an overall allocation, depending on the investor profile.

The author currently holds 2% of personal assets in VCVSX.

[Securities mentioned: SPY, IEF, AGG, LQD, HYG, MUB, VFINX, VFITX, VWITX, VBMFX, VWESX, VCVSX, VWEHX, JQC, NCV, AVK, CHY, CHI]

Richard Shaw
QVM Group LLC