JPMorgan Global Convertibles Income Fund — Update 6 October 2016

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JPMorgan Global Convertibles Income Fund Limited (JGCI) is a new investment company, incorporated in Guernsey and to be listed on the Main market of the London Stock Exchange. The fund aims to deliver an initial dividend yield of 4.5% based on the issue price together with potential long-term growth. The investment universe consists of global convertible bonds and other suitable instruments exhibiting convertible or exchangeable characteristics. While a significant category with a global value of circa $500bn, it qualifies as a niche segment when compared with equities and bonds. The fund will be the only UK-Iisted, closed-end fund addressing this market.

An active manager in this space requires a blend of equity and credit-related skills. The portfolio will be managed by Antony Vallee, who heads the five-strong JPMorgan Asset Management convertibles investment team. He has 15 years’ experience in the convertibles market, both in long-only and arbitrage strategies. (See page 10 for a description of JPMorgan Asset Management’s capabilities in this area.)

Convertible bonds combine characteristics of bonds and equities. This provides investors with an opportunity to hedge their bets in allocating between the two asset classes. We see the asset category as particularly appealing to those seeking higher returns but who are concerned by the historically depressed level of government bond yields, the tail risk of a spike in inflation and the mixed macro and earnings newsflow relating to equities. In periods of equity market or specific stock weakness the bond component of a convertible provides an element of downside protection while in a stronger market phase the equity element means a convertible bond would participate in the positive movement. Were interest rates to rise sharply the equity option in a convertible would mitigate the impact from the bond component of the valuation.

There is also the attraction of tapping into a niche segment that has historically offered attractive risk-adjusted returns compared with both equities and bonds (see Exhibit 4, page 7). Convertible bonds tend to trade more actively than conventional corporate bonds and, for those bonds migrating to bond-like or equity-like status, price movements can be more significant than normally seen in the bond market. This means they are well suited to an actively managed fund, while a closed-end structure obviates the liquidity constraint present for an open-ended fund.

To meet the company’s objective of generating both income and the potential for long-term growth the manager intends to focus on two areas within the convertible universe: high-yield bond-like convertibles and convertibles that fall into the balanced category (see Exhibit 3, page 6) where they are more sensitive to movements in the price of the underlying equity. The bias is likely to be towards smaller and mid-cap names as this is where a large portion of convertibles issuance takes place and also because there is a liquidity premium available that a closed-end fund is well-placed to exploit.

The fund manager places great emphasis on the investment process to ensure that the approach taken is repeatable and to facilitate analysis of decisions. Having established the requirements of the fund a customised screening tool is used to narrow down investment candidates before appropriate credit and equity-related analysis is undertaken. The fund is expected to have 60-80 holdings, which should provide adequate diversification without diluting the selection process unduly.

Convertible bonds combine characteristics of a bond and an equity investment. A typical convertible bond, like a corporate bond, pays a fixed income (coupon) with the option of redemption at face value (like a normal bond) or conversion into the underlying equity at a predetermined rate (for example, at a 30% premium to the equity price at time of the bond issue) at a particular date.

From the issuing company’s perspective, a convertible bond offers a way of raising capital to fund growth or to refinance that costs less in terms of interest coupon than a straight loan and may have less restrictive covenants. The conversion rate is set at a premium to the current stock price and a convertible can also find a more ready acceptance than a straight equity issue, depending on market timing and the specific circumstances of the issuer.

For the investor, a convertible bond offers a way of investing in a company that provides fixed income initially with the potential for participation in equity upside thanks to the conversion option that forms part of the bond. In addition to a normal yield premium compared with the equity, the bond element of the security confers some downside protection in the event of adverse developments relating either to the specific issuer or for the equity market in general.

As an example, the table below shows some data for a Steinhoff International Holdings1 euro-denominated convertible bond that falls within the investable universe for the fund. Calculations for the premium of the market conversion price are shown, which recently stood 70% above the stock price for Steinhoff. This is significantly above the 32% premium at the time of the bond issue in March 2011, reflecting primarily depreciation of the South African rand, which means that the share price in euro terms has fallen by about 20% while in rand terms it is virtually unchanged. Delta, a measure of the sensitivity of the bond to movements in the Steinhoff share price, is 27%, modestly below the expected delta for the portfolio of c 30%. The bond is therefore relatively equity-insensitive and, as mentioned, its euro denomination has provided a measure of currency protection over the period since launch when compared with direct ownership of the stock. The bond has a current or running yield of 4.4%, compared with the illustrative portfolio yield of c 5.2% while the issue size of approximately $600m is relatively large, suggesting the potential for better than average liquidity (most issues are between $100m and $500m – source JPMAM).

Exhibit 3 is an illustration of how the bond and equity components of a convertible bond might interact at different stock price levels (horizontal axis). The solid line represents the price of the convertible. At the right-hand side of the chart, where the conversion price is below the stock price, the convertible is in-the-money and its price moves closely with the equity price. Towards the left-hand side, in the out-of-the-money segment, the convertible is valued as a bond and does not respond significantly to marginal moves in the stock price; this is where the downside protection, or bond floor, of a convertible is evident. On the extreme left, were the company to become distressed, the bond, as with any corporate bond, is exposed to default risk: hence the illustrative price line trends to zero in this segment. The company intends to invest in the out-of-the money and balanced segments in order to benefit from superior yield compared with the in-the-money category and the potential for selected bonds to move up the curve between categories.

While convertibles have shown an attractive risk/reward balance historically (see “Track record for convertibles” below), investment in convertibles does carry the risks associated with either bond or equity investments.

By their nature, convertible securities will tend to be issued by companies that need to raise finance and are less able to access bank credit, corporate bond markets or the equity market. Thus for the convertible market as a whole there is a relatively high exposure to smaller and mid-cap companies (56% of the universe – source JPMAM) and to non-investment grade and unrated issuers (67% of universe).

The manager indicates that the default rate for convertible bonds in the segment the company will focus on (3-4%) is similar to that in the equivalently rated corporate bond market. A managed fund can mitigate this risk through diversification and, potentially, through detailed credit analysis. For reference, a recent S&P forecast for US speculative grade corporate default rate in 2013 has a central value of 3.4% within a range from 2.3% to 5.5%, depending primarily on macroeconomic developments. This compares with the long-run (1981-2013) average default rate of 4.5% and default peaks of 12.5%, 10.8% and 11.5% in 1991, 2002 and 2009 respectively.

Macroeconomic developments pose a risk both to the underlying operations of the issuers and, through interest rate changes, to the valuation of both the bond and equity components of a convertible bond. Specific problems at an issuer would affect the valuation of a balanced or in-the-money convertible, although the presence of the conversion option could reduce the equity-related downside as increased volatility would tend to increase the value of the option.

As an indication of the main influences on convertible bond prices, a study by Lummer and Riepe2 shows that between 1973 and 1992 US convertible bonds were highly correlated both with large- and small-cap equities (0.90 and 0.86 respectively) and only to a lesser extent with corporate bonds (0.47 long-term and 0.53 intermediate-term bonds).

The relatively attractive risk/reward offered by convertible bonds over the last near-decade are illustrated in Exhibit 4 below, which shows that the UBS Global convertible bond index both outperformed the MSCI World and S&P 500 equity indices and recorded substantially lower volatility.

Intuition suggests that convertibles would tend to perform somewhere between bonds and equities and the study by Lummer and Riepe, using earlier data for the 1957-92 period, does fit with this expectation. The first set of data for the whole period in the upper section of Exhibit 5 shows that convertible bond returns and volatility, as measured by standard deviation, did fall between bonds and equities. However, the second section of the table demonstrates that the outperformance shown in Exhibit 4 above has not been unique with convertibles also producing a stronger return than both equities and bonds in the 1973-92 period and scoring only a slightly higher standard deviation than long-term corporate bonds.

The global convertible bond market has a value of c $500bn. This compares with values for the global, non-financial, corporate bond market ($12,697bn, BIS, end September 2012) and equity market ($57,286bn, WFE, end-March 2013). While it is a significant market for a dedicated fund to address, the scale comparison makes clear why this is something of a niche area and why there may be inefficiencies for an active manager to exploit.

Geographically, the Americas is the largest market, accounting for 53% of the total (see Exhibit 6). In terms of credit quality 33% of the universe is investment grade. The manager’s illustrative portfolio has an average credit rating of BB, the second-highest sub-investment grade on the S&P scale.3

Convertible bond issuance has varied over time according to market conditions. As over 70% of the global convertible universe matures within five years it is important for a specialist convertible fund that there is a reasonable flow of new issues to maintain an active and liquid market. The manager also indicates that convertible bonds typically perform strongly in the first six months following issuance. Exhibit 8 shows that global issuance has been “spiky” with peaks in 2001 (post-tech bubble) and 2007 (pre-financial crisis trough). From 2007 to 2012, issuance tailed off, in part reflecting reduced interest costs and the increasing availability of bank and straight corporate bond credit. This year annualised first-quarter issuance was more than 60% above the prior-year rate led by a near 90% increase in small-cap issuance. We would be surprised were this rate of increase to be maintained (US issuance in Q1 was up only 7% on the 2012 average rate), but it may well signal the beginning of a recovery in activity. Reflecting this, and the relative strength in small-cap issuance (see Exhibit 9), the manager looks for further increases in demand for financing from small- and mid-cap companies, an area the company portfolio is likely to have a relatively high exposure to.

Continuing the focus on issuance, the manager has noted the resurgence in activity as companies look to benefit from investors’ search for returns from higher-risk assets. Examples highlighted include convertible issues in the last six months by global large caps Nokia, Arcelor Mittal and Sony, where appetite for a straight equity issue might have been constrained but where the risk/reward characteristics of a convertible were appealing and contributed to strong performance post-issue. More generally, the manager notes that while larger-cap issuers may enter and leave the convertible market according to the availability of alternative funding, there is a more consistent flow of issues from smaller and mid-cap companies across the global market. The manager expects the share of issuance of the small- and mid-cap companies to continue to rise with investor appetite exceeding the level of issuance, creating significant pent-up demand with potentially positive implications for valuations.

After a strong performance in 2012 for convertibles (+12.5%) and with an unclear outlook for both equity and bond markets it is interesting to consider the prospects for the market. For those uncertain about the outlook and seeking income we would argue the relative attractions of the convertible market are clear: the bond component provides some downside protection in the event of an equity market correction. The manager’s view is that credit spreads are likely to be fairly stable this year, but any weakness in bond markets prompted by changes in monetary policy, a (further?) rotation into equities or an uptick in inflation would be ameliorated by the equity exposure within convertible bonds. A strong upward movement in the equity market would, in our view, probably leave convertibles lagging but still better off than a straight bond investment.

JPMorgan Asset Management’s five-strong convertible bond investment team is led by Antony Vallee (head of convertibles), who is to be manager responsible for the company portfolio. He has 15 years’ experience in the convertible bond market, including long-only, arbitrage and equity-linked strategies. Prior to joining JPMorgan Asset Management in 2007 he had asset management roles at SYSTEIA Capital Management and HSBC Asset Management. He has degrees in finance, applied mathematics and economics and is a CFA Charterholder. Other members of the team are Natalia Bucci, who is an experienced portfolio manager with seven years’ experience in convertibles; Robin Dunmall, a junior portfolio manager with four years’ experience and an economics background; Benoit Lanctot, a convertible capital structure analyst with seven years’ experience in both analysis and origination; and Nicolas Hurley, who carries out convertible bond market research and has an engineering background.

Importantly, the team can draw on the broader resources of JPMorgan Asset Management. In overall terms this means being able to call on the expertise of about 300 equity analysts and portfolio managers, while the credit and global strategy teams also provide input to the decision-making process.

A separate investment director and dedicated convertible bond traders provide investment oversight and market know-how respectively. Risk, compliance and performance reporting capabilities all benefit from the scale of the JPMorgan Asset Management business.

Within the convertible bond area, JPMorgan Asset Management manages funds under five broad groups: balanced, conservative, yield-focused total return, income and flexible total return. In total, assets under management are approximately $4.4bn, including c $0.3bn in the income category that is closest to the company’s mandate. The direct overlap of existing funds with the company’s mandate is therefore relatively modest and, given its experience in running a range of funds, JPMorgan Asset Management has well-established procedures for addressing any potential conflicts of interest between different mandates.

While the management company’s scale in the convertible market could, on occasion, give rise to liquidity limitations for certain securities, there is a strong countervailing advantage when it comes to participation in new issues. As noted earlier, these are important in the market and larger investors tend to be given the opportunity to participate more fully in the issues. As Exhibit 10 below illustrates, JPMorgan Asset Management’s participation in new issues has ranged between 31% and 45% by number, while the six-month post-issue performance of issues in which the company participated outperformed the average on a global basis (8.9% versus 7.7%).4

To achieve the company’s objective of providing investors with income and the potential for long-term growth, the manager intends to invest in both bond-like convertibles, where yield is the key attribute, and the balanced segment where bonds are closer to in-the-money convertibles, which are equity proxies. The portfolio is likely to include high-coupon convertibles issued by small- and mid-cap companies where a liquidity premium helps to boost income and higher equity betas increase the equity sensitivity of the portfolio. The MSCI World is the reference index for the fund, but the portfolio will not be benchmark driven.

The manager will take into account top-down and bottom-up considerations. From a top-down perspective the fund will rotate strategically between more defensive bond-like convertibles and more equity-sensitive securities according to an assessment of the prospects for yields and overall convertible market valuations. Bottom-up factors include individual company analysis, industry outlook and technical factors for the specific convertible.

As shown in Exhibit 1, page 3 and Exhibit 12, page 13, the illustrative portfolio put forward by the manager has features that reflect the company’s income mandate. The lack of exposure to Japan reflects the low running yield available in that market, while the illustrative delta (equity sensitivity) of c 30% is low relative to a balanced strategy as the portfolio would include more bond-like investments.

While the company will have the ability to use gearing up to 20% of net assets, the manager indicates that the current intention is not to deploy this capacity initially and it is viewed as a tactical tool rather than a structural means of enhancing income.

Looking ahead, the manager believes there is increased interest in the asset class following an improved performance over the last year (BofA ML Global Convertible total return USD index +8% year to end March). The manager also sees a shrinkage in the US market as convertible bonds mature as likely to increase investor focus on European and Asian convertibles (having said this, the illustrative portfolio has a still substantial exposure of over 50% in the US). Higher running yields and betas in the small-cap sector are viewed as relatively attractive, favouring exposure to this area.

As noted, one of the key attractions of a convertible bond can be the measure of downside protection it offers if an underlying equity performs poorly. The flipside of this is that an out-of-the-money bond would not participate fully if the underlying equity performed very well: this is the opportunity cost for the downside risk mitigation and superior yield characteristics.

Another feature of the market, in common with most corporate bonds, is that the issue size is modest and therefore can be subject to the risks associated with crowded trades. This risk is reduced to some extent by the closed-end structure, which obviates the need to provide for liquidity or sell at an inopportune time.

The greater small-/mid-cap exposure and somewhat lower diversification compared with a balanced convertible bond strategy may result in relatively higher credit risk.

While the main exposure is set to be to convertible bonds, notes and preference stocks, the manager may also invest in other convertible instruments including synthetic convertibles, use derivatives and hold equities post-conversion and corporate bonds. Some of these may expose the fund to counterparty risk in addition to other market risks.

Given the global mandate, the majority of the company’s assets are likely to be denominated in non-sterling currencies and the company normally intends to hedge the value of non-sterling assets and income. The company will not engage in speculative currency or interest rate hedges.

Investment restrictions set by the company are as follows.

There will be no formal constraints on geographical, sector or market capitalisation exposure. However, the manager has indicated that the investment process (see below) dictates practical limits to mitigate risk and in practice individual holdings are unlikely to be above 5% of assets. The expected range of holdings is between 60 and 80 securities. The portfolio will also be diversified by geography and market capitalisation helping to meet the requirement that “the company will at all times invest and manage the portfolio in a manner consistent with spreading investment risk”.

Antony Vallee has emphasised that he places great emphasis on maintaining a consistent process in managing funds. He regards this as important in enabling repeatability and analysis of decisions.

The investment strategy for the company has a clear focus on income, so the initial strategy-setting part of the investment process is predetermined and the manager will set risk allocation and positioning based on this.

An important tool for the convertibles team is the customised screening system that has been developed over four years based on Monis software. It covers the global convertibles universe facilitating convertible pricing and provides a range of portfolio management tools. Screening trims the number of candidate investments and is a necessary but not sufficient step in the investment process.

Having narrowed the search, the team will then, depending on the nature of the company, carry out more or less in-depth research covering convertible bond technical aspects and credit and/or equity analysis of the situation. The manager may attend company meetings and also works with analysts and portfolio managers from other teams within JPMorgan Asset Management to keep track of companies’ progress. Fuller analysis tends to be carried out on smaller names as these are less likely to be followed by the equity team at JPMorgan Asset Management.

In order to ensure clarity of communication among the team and with dealers the team allocate a ranking to the companies they are following. Simplistically, stocks in the top category would all be given an equal weighting in the portfolio to ensure that each of the selections is able to have an equal impact on performance.

The distinguishing features of the fund, in our view, are fourfold: it is global, convertible/income-focused, closed-ended and UK-listed. Each of these is likely to give the fund particular characteristics.

As a global fund it is able to address the full convertibles universe and seek liquid opportunities according to market conditions. The convertible/income focus is evident in the illustrative portfolio running yield of 5.2% and is accompanied by its focus on the out of the money and balanced segments (note the lower equity sensitivity and lack of Japanese exposure in the comparison below, both reflecting the income mandate). A closed-end fund has an advantage in the relatively small convertible bond market. Open-ended funds need to retain liquidity and this may dictate a minimum issue size or greater diversity of holdings (illustrated in the table below) that could dilute concentration on preferred stocks. We believe the company will be unique as a UK-listed convertible closed-end investment fund providing investors here with access to this niche market through a suitably structured fund.

The company target is for an initial gross dividend yield of 4.5%. Dividends will be payable half-yearly in the first year with the intention being to move to quarterly payments thereafter.

Subject to an individual’s tax position, the treatment of dividends from the company may be more favourable in the UK than would be the case for income from an open-ended fund. Distributions from an open-ended convertibles or bond fund may be counted as savings income and hence incur the investor’s marginal tax rate. The proposed company, by dint of its Guernsey incorporation, may pay no tax itself on interest receipts and a UK investor may pay the lower marginal rate of tax that applies to dividends.

We interrogated the Morningstar database for existing funds investing in convertibles and identified 40 funds. We have already noted the advantage of a closed-end structure for investing in this area because of the liquidity limitations for some issues. Given this, and to give greater comparability with JGCI, we narrowed the group to closed-end funds only. In a further step we removed four with exposure of 30% or less to convertible instruments. This left just six funds (our “select group of CEFs”), all of which are US-based and predominantly invested in US securities and therefore differentiated from JGCI with its proposed UK listing and global diversification.

Exhibit 13 below shows selected data for these funds and the averages for the select group and all funds. We have also shown comparative figures for equity, convertible and bond indices. We would highlight the following points from the table.

Simon Miller (chairman and chairman of the Remuneration and Nomination Committee). Simon Miller is chairman of Dunedin LLP. Mr Miller is also chairman of Brewin Dolphin plc, Artemis Alpha Trust plc, Blackrock North America Income Trust plc, Amati VCT plc and a non-executive director of Scottish Friendly Assurance Limited. He was previously chairman of JPMorgan Elect plc. Mr Miller is resident in the United Kingdom.

Philip Taylor FCA (chairman of the Audit Committee). Philip Taylor is chairman of Hawksford International Limited, The States of Jersey Treasury Advisory Panel and The Jersey International Business School, Regional Chair of Coutts Channel Islands, non-executive director of Royal Bank of Scotland International and City Merchants High Yield Trust Limited, a member of the Audit Committee of the States of Jersey and a member of the Conduct Committee of the Financial Reporting Council. Formerly he was a partner of PricewaterhouseCoopers’ United Kingdom and Channel Islands firms and senior partner of PricewaterhouseCoopers Channel Islands from 1998 to 2007. Mr Taylor is resident in Jersey.

Paul Meader is an independent director of a number of investment management companies and investment funds including BlueCrest AllBlue Fund Ltd and ICG-Longbow Senior Secured UK Property Debt Investments Limited. He was, until recently, head of portfolio management for Collins Stewart based in Guernsey, having previously held the role of chief executive of Corazon Capital Group, which was acquired by Collins Stewart in 2010. Mr Meader has 26 years’ experience in financial markets in London, Dublin and Guernsey following senior positions in portfolio management and trading, with particular expertise in fixed income investments. Prior to joining Corazon he was managing director of Rothschild’s Swiss private-banking subsidiary in Guernsey. Mr Meader is a Chartered Fellow of the Chartered Institute of Securities & Investments and is past chairman of the Guernsey International Business Association, of the International Bankers’ Association and of the Guernsey Investment Managers’ & Stockbrokers’ Association. He is resident in Guernsey.

Charlotte Valeur Adu is managing director of GFG Ltd, which she founded in 2011. Prior to GFG, Ms Valeur Adu was the managing partner of Brook Street Partners Ltd from 2003. Ms Valeur Adu is the chairman of the board of Brevan Howard Credit Catalysts Limited and also serves on boards and committees of a number of listed and unlisted fund management and investment companies. Ms Valeur Adu has in excess of 30 years' experience in the financial markets. Prior to Brook Street Partners, she was a director in Capital Markets at Warburg, BNP Paribas, Societe Generale and Commerzbank. Ms Valeur Adu began her career in Copenhagen in 1982 with Nordea A/S. In 1991 she moved to the London office of Nordea A/S as head of the UK fixed income sales group. Ms Valeur Adu is a member of The Institute of Directors and is regulated by the Jersey Financial Services Commission in the conduct of Trust Company business. Ms Valeur Adu is resident in Jersey.