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Investors in convertible securities, barring default, can benefit from a steady income stream and the repayment of principal at maturity, while retaining the option to share in potentially higher equity values. The bond-like characteristics of convertibles provide downside price support, while the embedded equity option provides upside potential. In consideration of this upside potential, investors receive a lower coupon payment on the principal amount of the bond. Therefore, the price behavior of a convertible bond is influenced by both the fixed income value and the common stock price (Chart 1).
PIMCO’s convertibles practice leverages off our extensive experience and unmatched resources dedicated to the analysis and modeling of interest rate risk, volatility and embedded options, as well as disciplined fundamental bottom-up company/credit research.
Convertible securities, whether considered as a separate asset class or as part of an opportunistic asset allocation strategy, may offer attractive volatility-adjusted returns relative to both equities and straight corporate bonds. Recognizing these potential benefits, many of our clients have expanded their guidelines to allow the use of convertibles in their portfolios.
Balanced Risk Profile – We maintain a balanced risk/reward profile, emphasizing modest participation with rising equity prices yet providing a shield against significant declines.
Total Return Orientation – PIMCO emphasizes issues with capital appreciation potential and good credit fundamentals.
Broad Industry Focus – We diversify risk across multiple industries and sectors.
Quality Focus – PIMCO’s higher quality orientation typically results in portfolios with a higher average credit rating than that of the overall convertibles market.
Duration – We use an effective, option-adjusted duration, which will typically not exceed three years.
Equity Exposure (Delta) – The portfolio’s weighted average delta (a measure of the portfolio’s sensitivity to changing equity values) will generally not exceed 70 percent.
The valuation of convertibles is complex, requiring sophisticated option modeling as well as disciplined company/credit analysis. Successful analysis of convertibles involves several considerations:
Market Outlook – Portfolio risk management is guided by PIMCO’s long-term secular outlook that considers trends in demographics, political factors, and structural changes in the global economy. This annual outlook is refined with quarterly business-cycle economic forecasts that focus on near-term trends in inflation, GDP, and corporate profits. Results of our secular and cyclical forecasts influence the formulation of strategies for the convertible bond product.
Fundamental Analysis – In-depth analysis seeks to identify companies with stable or improving credit fundamentals and prospects for improving equity prices. PIMCO’s experienced in-house credit team evaluates the strength and predictability of each company’s cash flow, the quality of assets, the strength of the management team, the company’s competitive stance and financial flexibility, and the covenants of the convertible security.
Options Analysis – The analysis of the convertible’s attached equity option or warrant is performed in conjunction with PIMCO’s highly skilled team of financial engineers. The team is experienced in modeling and evaluating very complex financial processes, including the assessment of warrants associated with convertible securities. Our financial engineers are also skilled in reverse-engineering deal structures and in measuring and modeling volatility.
For evaluating corporate credit, we place a great deal of importance on independent analysis. PIMCO does not rely on the rating agencies alone. Our staff of seasoned credit analysts internally rate every credit held in our portfolios. Our research is focused on finding issues that exhibit improving credit profiles and the potential for capital appreciation. A prerequisite to evaluating an issuer is to have access to their management. We concentrate our efforts on companies that have a sound underlying business, as well as a formidable competitive position within their industry.
At PIMCO, we have always believed that in order to make independent decisions we need to control the means to analyze all investment alternatives considered for a portfolio. As a result, significant resources and talent have been applied to building a library of in-house analytical software to help identify and quantify the risks inherent in different portfolio structures/strategies, specific bond market sectors, and securities within those sectors. Over the years, that effort has grown considerably, as technology has become increasingly important in the financial marketplace.
PIMCO’s proprietary analytical models allow us to identify inefficiencies in the convertible bond market. We strive to take advantage of these market inefficiencies as another source of potential value added.
Composition of the Convertible Market
The global convertible market has experienced rapid growth recently and non-U.S. issues now account for over half of the market. The convertible market is very diverse, populated with multiple financing structures such as zero coupons and mandatory convertibles across all sectors and industries, and with an investor base that includes hedge funds, convertible arbitrageurs, and institutional managers.
Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Convertible securities may be called before intended, which may have an adverse effect on investment objectives. PIMCO strategies utilize derivatives which may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose mo more than the amount invested. The credit quality of a particular security or group of securities does not ensure the stability or safety of the overall portfolio. There is no guarantee that this investment strategy will work under all market conditions and each investor should evaluate their ability to invest for a long-term especially during periods of downturn in the market. Diversification does not ensure against loss.
This material contains the current opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2013, PIMCO.
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