Part 2: Hold the middle ground

Part 2: Hold the middle ground

Dogged by lingering memories of the 2008–2009 bear market, many investors remain cautious about increasing their exposure to equities — even though equities today offer compelling value relative to most fixed-income asset classes. At the same time, many bond investors are finding it necessary to assume greater credit risk to capture higher yields amid a generally low-yielding fixed-income environment. An actively managed approach to investing in convertible securities may offer a welcome middle ground for investors in either of these camps.

A unique security
Convertibles are hybrid securities, typically issued as corporate bonds or preferred stock. They give investors the option to convert to a specific number of shares of a company’s common stock within a specified time period. This hybrid nature affords investors a unique opportunity. First, convertible investors benefit from both the enhanced income (relative to equity dividend yields) and downside protection offered by the convertible’s fixed-income portion, a benefit that eludes investors in common stock. At the same time, convertible investors can profit from the potential price appreciation of the issuer’s common stock, a benefit that eludes holders of corporate bonds.

Issued by many types of companies
A wide variety of companies gain access to capital via the convertibles market, including rapidly growing companies and more traditional “value” companies. Larger companies recognize the advantages of issuing convertibles, since they can diversify their funding sources, often at a lower cost of capital versus other alternatives.

Offering multiple benefits to investors
Convertibles offer investors several potential benefits, including the potential for enhanced risk-adjusted performance, income potential, opportunity for capital appreciation, and lower principal risk.

As seen in the chart below, Putnam Convertible Securities Fund produced positive returns and outperformed the S&P 500 Index during the so-called “lost decade” of 2000–2010 — a time when passive equity strategies generally lost ground.

Current performance may be lower or higher than the quoted past performance, which cannot guarantee future results. Share price, principal value, and return will vary, and you may have a gain or a loss when you sell your shares. Performance of class A shares before sales charge assumes reinvestment of distributions and does not account for taxes. After sales charge returns reflect a maximum 5.75% load. A short-term trading fee of 1% may apply to redemptions or exchanges from certain funds within the time period specified in the fund’s prospectus. 

S&P 500 Index is an unmanaged index of common stock performance. You cannot invest directly in an index Indexes are unmanaged and used as a broad measure of market performance. Past performance is not indicative of future results. View the most recent month-end fund performance.

Convertibles also provide the opportunity for income potential. In fact, during the past 10 years, the yield on the BofA Merrill Lynch All U.S. Convertibles Index has been higher than the dividend yield on the S&P 500 Index. As of September 30, 2010, the yield on the BofA Merrill Lynch All U.S. Convertibles Index was 3.49% versus 2.03% for the S&P 500.*

While a convertible’s fixed-income component can help mitigate downside risk if the issuing company’s common stock underperforms, the underlying equity option allows the holder to participate in a portion of the upside if the stock performs well. Although investors do not typically participate in 100% of the movements in the underlying stock, historically they have participated in a greater proportion of the upward movements than the downward movements because of the downside protection provided by the convertible’s bond element.*

Lastly, convertibles generally carry a lower level of principal risk than common stock because they are more senior in a company’s capital structure. In the event of bankruptcy, convertible holders receive preference over common shareholders, although there is no guarantee for any stakeholders in bankruptcies. That said, there are times when convertibles tend to underperform. Specifically, during downturns in the credit cycle when equity markets don’t follow suit, convertibles have often lagged the broader equity market. Convertibles may also underperform during equity bull markets when the market is being driven by a narrow range of stocks, such as during the boom of the late 1990s. And, like all securities, convertibles have specific risks associated with them. These risks include the higher default risk associated with lower-rated securities.

The case for active management
An actively managed approach is vital, in our view. Properly evaluating a convertible security requires a combination of equity, fixed-income, and structural analysis, all of which require experience, time, and resources. At Putnam, our strength in managing convertibles for more than 35 years comes from our extensive experience, the vast internal resources we draw upon, and our disciplined, holistic approach to analyzing convertible opportunities.

Recent performance and outlook
After returning an exceptionally strong 53.7% in 2009, Putnam Convertible Securities Fund continued to advance solidly during the first 10 months of 2010, returning 13.54% (class A shares at net asset value). U.S. equities, meanwhile, gained 7.84% year-to-date through September, as measured by the S&P 500 Index. Convertibles benefited from narrowing corporate credit spreads — which reflected better profitability, stronger balance sheets, and improved borrowing conditions for corporations — and from generally supportive equity market conditions.

Regarding our outlook, we evaluate the convertibles market by looking at three key factors: fundamentals, valuation, and “technicals,” or the balance of supply and demand. As of now, we are positive on fundamentals and technicals, and neutral on valuation. Looking first at fundamentals, we believe the U.S. economy will continue to slowly improve, and we anticipate that corporate earnings will continue to benefit from the stringent cost cutting implemented in 2009, combined with recovering demand. Regarding technicals, in our view, the environment remains supportive. Convertibles continued to attract “crossover” equity and corporate bond investors seeking better risk-adjusted total returns, while the supply of new securities remains constrained.

As for valuation, in 2009 and early 2010, convertibles rallied substantially from the historically cheap valuations reached during the height of the credit crisis. So, while convertible valuations are somewhat higher, we believe there are still pockets of value to be uncovered due to ongoing inefficiencies in the market. And it is these inefficiencies that provide us with a continual stream of investment opportunities that we seek to capitalize on through our bottom-up research process that combines equity, fixed-income, and structural analysis.

* Source: Putnam research, 2010.

The BofA Merrill Lynch All U.S. Convertibles Index is an unmanaged index of high-yield U.S. convertible securities.

The fund may invest a portion of its assets in small and/or midsize companies. Such investments increase the risk of greater price fluctuations. Lower-rated bonds may offer higher yields in return for more risk. Funds that invest in bonds are subject to certain risks including interest-rate risk, credit risk, and inflation risk. As interest rates rise, the prices of bonds fall. Long-term bonds are more exposed to interest-rate risk than short-term bonds. Unlike bonds, bond funds have ongoing fees and expenses.

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