Convertible bonds are corporate bonds that may be exchanged by the holder for a fixed number of ordinary shares. They can be regarded as a combination of a fixed income instrument and a stock option, with the bond limiting downside risk and the option providing equity participation. Convertibles increase in value alongside equi-ties in rising markets, while being protected from the inevitable sharp declines — the value of the underlying bond provides a floor value and prevents the market price from falling with equities past a certain level. This bond-floor “parachute” makes convertibles a less painful way of participating in a company’s equity when things go wrong. Moreover, convertibles have proven that they can perform with a lower volatility than equities, and their option-like characteristics enhance their valuations in times of equity market volatility.
Still, convertibles have been overlooked by many investors. The asset class has developed significantly in the re-cent years but much misplaced fear and confusion persists. Concerns about a lack of convertible issuance appear unfounded; the market for convertibles is renewing itself at a normal rate of about USD100 billion a year. Another issue is whether convertible investments should be treated as an equity or fixed-income allocation. Convertibles should be seen as an entirely separate allocation that bridges the two classes, and investors might best view con-vertibles in terms of what contribution they can make to a portfolio as a whole.
For example, investors whose portfolios are limited to fixed income can use convertibles to gain equity exposure. For insurers and other investors with solvency constraints, convertibles’ uncorrelated returns has gained them favourable treatment under the European Union’s Solvency II rules. With the size of the global convertible market at about a quarter of that of the global high-yield market – which has a separate allocation in almost all institu-tional mandates – there is a strong case to be made for a dedicated convertibles allocation. Many companies limit their bond issues to convertibles. By excluding convertibles from their portfolios, bond investors in effect exclude these companies; conversely, convertibles can be seen as adding a dimension of diversification.
NN Investment Partners bases its investment philosophy on two convictions. One is that convertible bonds provide asymmetrical returns, as well as equity-like returns with lower volatility over the economic cycle. The second con-viction is that we can enhance these benefits and outperform the convertible bond asset class. We do this by se-lectively investing in convertible bonds with a clear and rigorous four step process that involves investment in convertibles that offer equity participation, combined with research-driven credit selection for capital preserva-tion, disciplined portfolio construction and strict risk control.
The scope of our investment universe is global, and the goal of our investment process is to single out the best investment vehicles issued by the most attractive companies related to our selected themes regardless of their region or sector. By using themes rather than sectors, we make use of dynamic rather than fixed stock classifica-tions that add clarity to what is driving companies valuations going forward. Our aim is to construct a portfolio of balanced convertible bonds that is well diversified from a name, sector and theme perspective. In an ideal world, performance over the cycle would come from a broad set of themes. Themes that have worked particularly well in the past are Memory Chip Cycle, US Consumer Spending, Real Estate Exposure and Health Care Spending. Our five biggest themes are currently Cloud computing, Corporate Rationalisation, Healthcare spending, Bank Deleveraging and Electronic Components.
NN Investment Partners does not simply invest in convertible bonds. We invest in companies, using convertibles as the vehicle through which to access them. This distinction should serve to reflect the discipline that our team tries to bring to the investment process as a whole, a process that leads to a concentrated portfolio of around 30 holdings.
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