Flat quarterly performance caps moderate return year

Q4 2021 Putnam Convertible Securities Fund Q&A

  • Growth-to-value shifts in market sentiment weighed on performance for the quarter.
  • While past performance suggests that defensive sectors tend to do best during mid- to late-cycle recoveries, today’s unique Covid-19 reopening environment makes historical comparisons challenging.
  • We believe relative returns for convertibles will be attractive on a cross-asset basis in 2022, especially in risk-adjusted terms.

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

Rising inflation, which led to fears of higher interest rates, weighed on the convertibles market and other rate-sensitive assets. Supply chain disruptions stemming from the pandemic, labor wage pressures, and higher energy prices fueled the inflation. Those concerns were validated when the Consumer Price Index jumped 6.2% and 6.8%, respectively, in October and November 2021 from a year earlier.

November was an especially challenging month when the Federal Reserve’s increasingly hawkish tone converted to policy. The Fed announced it would begin reducing its monthly purchases of Treasury bonds and mortgage-backed securities. Investors became concerned that the Fed might tighten monetary policy sooner and more aggressively than first expected to cool the U.S. economy. Those concerns were somewhat tempered by the mixed November jobs report and uncertainty brought on by the highly transmittable Omicron variant of Covid-19 and renewed pandemic restrictions. In December, the Fed communicated it plans to accelerate the winding down of its bond-buying program and end the program by March 2022. This prospect caused investors to pull forward their expectations for the Fed’s timing of rate increases in 2022.

The ICE BofA U.S. Convertible Index [the convertibles benchmark] posted a return of -0.03% for the quarter. The Bloomberg U.S. Aggregate Bond Index, a broad measure of U.S. fixed-income markets, and the S&P 500 Index returned 0.01% and 11.03%, respectively. Four of the 12 sectors within the convertibles benchmark posted positive results for the quarter, with the best results in utilities [9.77%] and materials [6.51%]. Media [–11.65%], transportation [–6.3%], and consumer staples [–4.91%] struggled the most. In terms of style and market cap, value-oriented convertible bonds slightly outperformed growth-oriented convertibles, while mid-cap convertibles outperformed large-cap and small-cap convertibles.

Given the sensitivity of convertibles to their underlying equities, why didn’t their performance keep pace with the equity rally somewhat more?

U.S. equities had a strong fourth quarter, as corporate fundamentals, earnings results, and forward guidance improved and propelled the S&P 500 Index to record highs. Convertibles did not fare as well due to the difference in the composition of securities underlying these two benchmarks. During the quarter and at other points during 2021, software and technology growth stocks with high valuations fell out of favor as interest rates rose. Investors rotated out of expensive technology securities into energy, materials, and other more traditional value sectors. These value sectors are not heavily represented in the convertibles benchmark. So, these stylistic shifts weighed on performance.

The convertible bond market comprises issuers of all market capitalizations as well as growth- and value-oriented companies. However, in the last few years, the composition has gradually shifted, with growth-oriented 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 approximately 60% of total market capitalization.

The composition of the convertibles market continues to broaden due to the robust new issue market, with more value and small-cap names coming to market in 2021. 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 the fund perform?

For the three months ended December 31, 2021, the fund’s class Y shares returned –0.20% [net of fees], underperforming the benchmark return of –0.03%. On a gross basis, the fund returned –0.01%, marginally outperforming the benchmark for the quarter.

On a relative basis, security selection within consumer discretionary was the largest contributor to relative performance. Underweight positioning in select reopening plays, such as cruise lines, added to benchmark-relative performance due to concerns about the highly contagious Omicron variant. Security selection within utilities and energy also aided relative performance.

On the other hand, security selection within technology was the largest detractor to the fund’s relative returns during the quarter. This was largely due to earnings-related volatility, specifically being underweight names that had positive results or traded down following announcements, regardless of their results. Underweight exposure to financials combined with overweight positioning and security selection within industrials also detracted from relative returns.

In 2021, the convertibles market encountered challenges. Rising inflation expectations led to an increase in interest rates. This led to a rotation in market leadership from technology, financials, and consumer discretionary to inflation-sensitive sectors, such as utilities, industrials, and telecommunications. We also saw an aggressive primary new issue market with a number of zero-coupon deals coming to market. [Zero-coupon bonds do not pay interest during the life of the bond. Investors buy them at a steep discount from their face value, which they receive when the bond matures.] Still, convertibles posted a positive 6.34% return for the year.

What is your outlook?

Changing Covid-19 case counts have been the biggest determinant of style rotations. U.S. stocks, which currently trade around 20 times earnings, are elevated but not near all-time highs. The earnings multiple in U.S. markets has generally fallen over the past eighteen months, as earnings growth has outpaced the expansion of share prices. While past performance suggests that defensive sectors tend to do best during mid- to late-cycle recoveries, namely utilities, health care, financials, and transportation, today’s unique Covid-19 reopening environment makes historical comparisons on this basis challenging.

As 2022 begins, there are three concerns weighing on our outlook for the asset class. What do higher interest rates and the threat of inflation mean for convertibles as an asset class? How are convertibles likely to perform in an environment of slowing economic growth? Does the ongoing pandemic recovery suggest the cyclical rotation will persist, and how will that impact the convertibles market?

Historically, convertibles have performed relatively well in rising-interest-rate environments. This is due to their lower duration, or price sensitivity, to rising rates compared with other fixed-income assets. However, an increasing proportion of today’s convertibles market is composed of high-growth issuers with high valuations that are more heavily affected by rising rates than other companies. However, we believe the asset class’s valuation reset over the course of 2021 has improved the convexity of the asset class, providing better downside protection on a relative basis. [Convexity is a tool that we use to manage the portfolio’s exposure to market risk.] In addition, rising-rate environments have historically accompanied attractive equity returns if the yield curve has not inverted. In other words, a mid-cycle economy has typically resulted in convertibles matching the returns of equity markets, with significantly less volatility.

In sum, we do expect performance in 2022 to be measured as convertibles have become less-positively correlated to rising rates, and global economic growth is healthy but slowing. Additionally, the cyclical shift may limit returns for growth names, which compose most of the asset class. That said, we believe relative returns may be attractive on a cross-asset basis, especially in risk-adjusted terms. Our thesis is based on the market’s improving convexity with respect to underlying stocks and declining credit sensitivity to interest rates.