Investing in Convertible Bonds with Attractive Risk/Reward Characteristics

“We are attracted to the downside protection that a convertible security’s bond feature offers, while also offering the ability to capture a significant portion of the upside in the issuer’s stock, given the convertible feature.”

At Prospector, we have had a long-standing attraction to convertible bonds (“converts”) and have utilized them as part of our capital appreciation strategy since its inception – viewing them as another tool in our value-investing toolbox. As with all of our products, in the capital appreciation strategy (available in both a private fund and a mutual fund), we focus on potential downside first when analyzing a security. Thus, we are attracted to the downside protection that a convertible security’s bond feature offers, while also offering the ability to capture a significant portion of the upside in the issuer’s stock, given the convertible feature.

Our process for investing in converts is very similar to our process for equities. We perform a similar, thorough, deep-dive analysis of each potential convert idea, much like we would for a common stock idea. We look for companies with solid balance sheets, good cash flows, and with a potential catalyst for significant upside in the issuer’s common stock. If we don’t believe the issuer is a solid credit, we will not invest in the convertible security – this means we pass on the VAST majority of converts we see. 

That said, we rarely buy a truly great company’s convert. This is primarily because “blue chips” typically aren’t issuers of converts, and there is more money to be made buying and holding the common stock of a great franchise. When we do buy a convert, it is usually a situation involving a decent business with a competent management team that attracts us – where we’re less sure of the future and a convert with appropriate upside/downside participation works best for the portfolio. 

Here are some additional considerations/preferences when analyzing converts:

1)      We generally invest in relatively short-duration converts. This could be by way of maturity or a put. We don’t like to take a lot of interest rate risk, and we also like to know we will have the ability to exit the name within a 3- to 5-year time period.

2)      We don’t like mandatory converts (which provide no bond floor).

3)      We don’t own them for income.

4)      We are sensitive to liquidity and will pass on an idea that we believe will be too hard to exit should the need arise.

Given the long bull market in bonds, and low-interest rate environment, there has been a decrease in the supply of converts over the past decade (with interest rates so low, there has been less of a need for companies to add a convert feature to be able to issue debt at a low rate). Thus, the capital appreciation strategy’s overall weighting in converts has decreased over time. Rather than invest in converts where we have less conviction, or with weaker credit profiles, we have instead opted to hold higher levels of cash and investment-grade low-duration corporates.  We are, however, always combing through the universe of converts, and watching for new issues, hoping to find an attractive prospect.

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The views described herein do not constitute investment advice, are not a guarantee of future performance, and are not intended as an offer or solicitation with respect to the purchase or sale of any security. Investing involves risk, including loss of principal. Investors should consider the investment objective, risks, charges and expenses of a Fund carefully before investing. Please review the offering memorandum or prospectus of a Fund for a complete discussion of the Fund’s risks which include, but are not limited to: possible loss of principal amount invested; stock market risk; value risk; interest rate risk; income risk; credit risk; foreign securities risk; currency risk and derivatives risk.

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