Convertibles weather rising rates and increased volatility

Putnam Investments, 04/21/21


Q1 2021 Putnam Convertible Securities Fund Q&A

  • Convertibles closed a volatile quarter in positive territory, supported by the strength of underlying equities in January and February.
  • The composition of the convertibles market continues to broaden due to a robust new-issue market, with more value, small-cap, and reopening issuers participating.
  • Convertible securities have performed relatively well in past rising-rate markets because they have low interest-rate sensitivity compared with other traditional fixed-income asset classes.

Please describe conditions in the U.S. convertibles market in the first quarter.

Convertible bonds encountered a surge in interest rates and increased volatility during the first quarter of 2021 but still posted positive performance. Due to their hybrid characteristics, the ICE BofA U.S. Convertible Index [the convertibles benchmark] rose 2.86% for the quarter, outperforming the -3.37% return of the Bloomberg Barclays U.S. Aggregate Bond Index [the fixed-income benchmark]. This result was due to the solid performance of convertibles’ underlying equities in January and February. The S&P 500 Index [the equity benchmark] climbed 6.17% for the quarter, repeatedly setting new highs. A closer look at the month-to-month performance of the asset class, however, portrayed a broader market environment in flux as it absorbed a variety of developments.

In January and February, the convertibles benchmark tallied monthly gains of just over 3%, outperforming the fixed-income and equity benchmarks. Below the surface, the market saw a cyclical rotation out of growth sectors, such as technology and health care, into value sectors, such as industrials, energy, and financials. Value stocks surged as a result, strongly outpacing growth stocks. Small-cap stocks also had a strong showing, considerably outperforming large-cap stocks. The increased pace of Covid-19 vaccinations and the FDA’s approval of Johnson & Johnson’s single-shot vaccine on February 27, 2021, heightened investor optimism about the economy’s reopening and recovery. Expectations for additional stimulus, which ultimately came to pass on March 11, 2021, with President Biden signing the $1.9 trillion American Rescue Plan, also fueled the rally.

Convertibles reversed course in March due to concerns about high-equity valuations and inflation fears. The sell-off in growth sectors, led by technology, particularly weighed on the performance of the asset class. The reversal appeared to be driven by high-equity valuations and concerns that further fiscal stimulus would result in higher interest rates and inflation. Just as the quarter came to a close, President Biden provided details about his $2 trillion infrastructure proposal. To help pay for the plan, corporations may be facing higher taxes, a headwind for profits. Higher-wage earners may also face higher taxes. Against this backdrop, convertibles succumbed to their underlying equity sensitivity, with the convertibles benchmark returning -3.15% for the month.

In fixed-income markets, interest rates climbed to their highest level since February 2020. The yield on the bellwether 10-year U.S. Treasury note rose from 0.93% on December 31, 2020, to a high of 1.74% on March 19, 2021, before closing the quarter at 1.73%. As a result, the yield curve steepened as short-term interest rates remained near zero, anchored by the Federal Reserve’s commitment to keep rates low.

Nine of the 12 sectors within the convertibles benchmark posted positive results for the quarter, with the best results in materials [21.81%], energy [21.74%], and transportation [20.57%]. Telecommunications [-4.46%], technology [-1.47%], and health care [-0.11%] delivered negative results. In terms of style and market-cap, value-oriented convertibles bonds [5.46%] outperformed growth-oriented convertibles [-0.21%], while small-cap convertibles [13.84%] outperformed mid-cap [6.92%] and large-cap convertibles [1.38%].

Why did the sell-off in technology stocks have such an effect on the performance of convertibles during the quarter?

The convertible bond market comprises issuers of all market capitalizations as well as growth- and value-oriented company securities. However, in the last few years, the composition of the convertible bond market has gradually shifted, with the growth-oriented technology and health-care sectors representing a larger percentage of the total market. As these companies have turned to the convertible bond market in increasing numbers during the past decade to gain access to capital, their combined weighting climbed as high as 50% of total market capitalization.

Given the technology sector’s dominance, the March sell-off, particularly in stay-at-home and Internet-related names, combined with the significant rotation out of growth into value, resulted in negative performance. The recent spike in interest rates also contributed to the underperformance of growth relative to value, as investors sold expensive technology securities as part of the broader shift into cyclical stocks. It is worth noting that the correction in high-growth technology stocks came on the heels of the sector’s strong performance in 2020, when many of these securities outperformed nearly all other asset classes.

We believe that if growth continues to drastically underperform, it could be a headwind for convertibles. However, the composition of the convertibles market continues to broaden due to the robust new-issue market, with more value, small-cap, and reopening names coming to market in the past year.

We continue to believe that a balanced portfolio across all investment styles and market caps should perform relatively well as investors digest potential outcomes and news.

How did you manage the fund in light of these market dynamics?

First we took advantage of select opportunities in the new-issue convertibles market, focusing on securities that were priced at what we believed were attractive valuations while avoiding securities selling at prices that we did not think reflected the future value of the issuer. Second, we sought out reopening plays, that is, companies poised to benefit from increased vaccinations, a return to work and school, and targeted federal stimulus.

We also trimmed securities with higher equity sensitivity in favor of more balanced profiles. As part of this strategy, we reduced the portfolio’s exposure to rate-sensitive instruments, such as bank preferred securities, and to rate-sensitive sectors, such as financials and utilities. This resulted in a lower delta, or equity sensitivity, of the portfolio. We believe a more balanced profile of capital preservation and reduced volatility from the bond component, as well as upside opportunity from the equity conversion option, will continue to help the fund achieve better risk-adjusted returns over the long term and weather volatile markets.

How did the fund perform?

For the three months ended March 31, 2021, the fund’s class Y shares returned 1.06% [net of fees], underperforming the convertibles benchmark.

On a relative basis, security selection within consumer discretionary was the largest detractor to relative performance, although the sector was the top contributor on a total return basis. Specifically, within consumer discretionary, underweight positioning in a couple of names that outperformed during the quarter weighted on relative performance. Overweight positioning and security selection within technology, as well as underweight positioning and security selection within industrials, also negatively affected relative performance.

On the other hand, underweight exposure to the financial sector was the largest contributor to the fund’s relative returns. This was due to higher rates during the period, which were a headwind for interest-rate sensitive convertible-preferred securities.

How were technicals in the convertibles market?

Market technicals remained healthy given very strong issuance and increasing attention from retail investors. New issuance during the first quarter of 2021 was up 188% year over year, allowing us to broaden sector diversification. Approximately 56% of the first quarter’s issuance was from first-time convertible issuers, according to BofA. This provided the opportunity to trade out of highly appreciated issues and replace them with more balanced new issues at par value. Demand also continued to be robust, with increased interest from crossover equity and fixed-income investors as well as convertible arbitrage hedge funds. As a result, companies were able to issue convertible bonds with lower coupons and higher premiums compared with those in recent years.

What is your outlook?

Convertible securities, given their hybrid features, can be subject to volatility associated with sharp equity and bond market moves, as we saw in the first quarter. However, convertibles have demonstrated their ability to provide asymmetric returns over longer periods of time, capturing over 70% of the upside of their underlying equities and roughly 44% of the downside during the last 20 years.

Our near-term outlook for equities and corporate credit is constructive. The vaccine rollout and further stimulus provide a positive backdrop for risk assets, in our view. In this environment, we believe there could be a continued rotation from growth companies to more value and cyclical companies. Should interest-rate and inflation concerns persist, the markets may continue to see bursts of volatility. However, convertible securities have performed relatively well in past rising-rate markets over time because they have low interest-rate sensitivity compared with other traditional fixed-income asset classes.

Our view of the convertibles market is also positive. Though growth companies constitute a significant portion of the market, we believe many of these companies could continue to perform very well in the post-pandemic period. Additionally, the constitution of the market has become more balanced, with securities in more value-oriented sectors, or beneficiaries of economic reopening, becoming a larger portion. We believe this makes the U.S. convertibles market a more balanced vehicle for exposure to a variety of growth and value companies with attractive yields.