Convertibles gain ground despite Fed's increasingly hawkish tone

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Q2 2021 Putnam Convertible Securities Fund Q&A

• The fund closed a positive quarter, supported by the strength of its underlying equities and exposure to reopening plays.
• The equity sensitivity of the U.S. convertibles market has declined recently due to the active new-issue market and the correction in growth equity names.
• We believe U.S. convertibles offer a balanced vehicle for exposure to a variety of growth and value companies with an attractive yield.

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

Supported by the strength of their underlying equities, convertible securities gained ground. The ICE BofA U.S. Convertible Index [the fund's benchmark] climbed 3.92% for the quarter. This performance fell between the 8.55% return of the S&P 500 Index, which repeatedly set new highs, and the 1.83% return of the Bloomberg Barclays U.S. Aggregate Bond Index, a broad measure of U.S. fixed-income markets.

During the second quarter, the increased pace of Covid-19 vaccinations strengthened investors' conviction about the U.S. economy's reopening. This optimism appeared to be justified by the announcement that first-quarter gross domestic product [GDP] increased at an annual rate of 6.4%. Expectations for the passage of an infrastructure bill also fueled the rally. However, some nervousness crept into the markets as investors worried that corporations and higher wage earners might see higher taxes to help pay for the plan. The markets also experienced bouts of volatility due to investors vacillating between optimism about the reopening of the economy and fears about rising interest rates and inflation as growth improved.

In May 2021, the Federal Reserve hinted it may soon consider scaling back its purchase of $120 billion in government-backed bonds each month while holding its benchmark rate near zero. Policymakers reiterated that they still needed to see more progress toward their goals of full employment and inflation averaging 2% over time. At its June 2021 meeting, the Fed assumed a more hawkish tone by saying it could start raising short-term rates by late 2023 if the recent high inflation continued. Fixed-income securities sold off, sending bond yields and the U.S. dollar higher.

Despite the Fed's commentary, interest rates trended lower during the quarter. The yield on the bellwether 10-year U.S. Treasury note declined from 1.74% on March 31, 2021, to 1.45% on June 30, 2021. Longer-term, rate-sensitive, fixed-income assets ended the period higher.

What was your strategy in this environment?

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 reopening plays, that is, companies poised to benefit from increased vaccinations, a return to work and school, and targeted federal stimulus. Many of the opportunities resided in the pandemic-stressed travel, leisure, and retail industries, as well as cyclical names, more broadly speaking. These securities came to market at prices that we viewed as very attractive.

We also trimmed securities with higher prices and high equity sensitivity in favor of more balanced new issues at or near par. 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 equity sensitivity [delta] of the portfolio.

How did the fund perform?

For the three months ended June 30, 2021, the fund's class Y shares returned 3.75% [net of fees], slightly underperforming its benchmark. On a gross basis, the fund returned 3.95%, edging out the benchmark for the quarter.

On a relative basis, security selection within consumer discretionary was the largest contributor to relative performance. Specifically, overweight positioning in select reopening plays added to benchmark-relative performance. Security selection within communication services and technology also aided relative performance.

On the other hand, underweight exposure and security selection within the energy sector was the largest detractor to the fund's relative returns during the quarter due to the strength in oil prices. However, energy is a relatively small sector within the convertibles universe, and our decision to underweight the exposure was due to our preference to invest in securities outside the industry. Security selection within utilities and real estate also marginally detracted from relative returns.

What is your outlook?

As we head into the second half of 2021, our near-term outlook for equities and corporate credit is constructive. The vaccine rollout, fiscal stimulus, and potential infrastructure spending 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.

Our view of the convertibles market is also positive. Although growth companies constitute a noteworthy portion of the convertibles market, we believe many of these companies could continue to perform well in a post-Covid-19 environment. Additionally, we believe the composition of the market has become more balanced, with reopening names and value-oriented securities becoming a larger portion of the market. Furthermore, the delta of the U.S. convertible market has declined recently due to the active new-issue market and the correction in growth equity names. Ultimately, we believe U.S. convertibles offer a balanced vehicle for exposure to a variety of growth and value companies with an attractive yield.