erdikocak
CEFA:
Welcome to CEF Insights, your source for closed-end fund information and education, brought to you by the Closed-End Fund Association.
Today we are joined by Tony Huang, Portfolio Manager with Advent Capital Management. Advent manages the Advent Convertible and Income Fund (NYSE:AVK).
We’re happy to have you with us today, Tony.
Tony Huang:
It’s great to be here on Insights.
CEFA:
I mentioned that Advent manages Advent Convertible and Income Fund, a closed-end fund with symbol AVK. Can you discuss the investment strategy for the fund and how the components of this convertible and high-yield strategy complement each other?
Tony Huang:
Well, at a basic level, both convertibles and high-yield bonds are in the corporate fixed income asset class. Convertibles can be either investment grade or not, but more importantly, they have an option at the investor’s choice to convert into equity if the equity does well enough. And of course, high yield is the non-investment grade side of the corporate bond world.
And so, these underlying issuers, they’re all corporations. They require a lot of company-specific research. And we here at Advent have a full research department dedicated to analyzing them, and our whole investment team here at Advent is able to find value in securities across the corporate capital structure. This actually even includes equities and bank loans, which are also smaller asset classes included in AVK, but over 80% of the assets in the fund are in the two that you mentioned, convertibles and high yield.
CEFA:
How do you determine the allocation between convertibles and high-yield and what would bring about a significant shift in the allocation?
Tony Huang:
Well, Advent assembles its portfolios on a bottoms-up basis, so our opinion of the individual company is paramount. We focus our research staff on making determinations on companies as opposed to macro calls. We do monitor broader trends, but it’s typically taken a meaningful change in the tenor of the financial markets to affect a large shift in allocation across asset classes.
CEFA:
The Federal Reserve raised interest rates by over 5% from March 2022 to July 2023. How did the AVK portfolio adjust during that period?
Tony Huang:
So, there is an example of a major change in the financial markets. At the start of what’s been a very steep Federal Reserve hiking campaign, AVK in January of 2022 was 65% of its assets in equity sensitive asset classes, convertibles and equities, and about 31% in high-yield bonds. At the end of the fiscal year that we recently ended, October of 2023, that had shifted. It was 51% in convertibles and equities and 45% in high-yield, and another bond asset class that we recently invested in, CLO securities. So, there has been about a 15% move towards straight bonds. We did shift allocations away from equity sensitive, knowing that those were potentially the most volatile. As short rates went up, floating rate securities became more attractive and AVK began investing a small portion into CLO securities, which pay interest off short-term rates.
CEFA:
Overall, could you characterize performance for AVK shareholders during 2023?
Tony Huang:
Yes. AVK’s return at NAV was just over 15% in calendar 2023. For the listeners here, that uses the closed-end fund market standard of assuming distributions are reinvested at the payout date back into more fund shares. That 15% return came a little less than 3% from the NAV changing, and the rest came from AVK’s monthly distribution.
Both of the convertible and high-yield universes had above average performance coming out of the year, and a lot of that came from the consumer discretionary sector, and there were some sub-sectors within them, like leisure and retail. Our strategies at the fund have been more heavily weighted in these areas, which gives you a sense of an important driver of performance for AVK in 2023.
CEFA:
Tony, the Federal Reserve appears to be holding rates at current levels. Inflation has improved, but remains a concern. Economic growth has been resilient, but federal deficits are challenging. We also have significant geopolitical tensions and US federal elections in November that potentially impact markets. Can convertible securities help a portfolio allocation in the current market conditions?
Tony Huang:
If I summarize your observations, economic conditions are decent now, but there is the potential for that to vary based on some of the factors you mentioned. In other words, the volatility could possibly increase, and this is where convertibles can help.
The equity option that’s embedded in convertible securities is priced on the volatility of the stock, so the more volatile the stock is, then the more valuable the option is and the more the investor can garner based on larger moves in the stock. So, if the volatility of that stock or the market’s volatility picks up, then that option is priced higher and that can be a nice pickup of value particular to this asset class. It acts especially useful as an offset in down equity markets, which often accompany higher volatility.
Last year, volatility fell and the VIX, the Volatility Index put out by the CBOE, the Chicago Board of Options Exchange, this is a crude measure of equity volatility, but nonetheless, it’s been below 15 most of the time since mid-2023. If volatility would rise from here with or without lower equity prices, you do have some potential source of alpha in the convertible asset class as volatility is priced historically relatively cheaply right now.
CEFA:
How does this position high-yield fixed income in the current market?
Tony Huang:
Well, high yield is more of a mixed bag on current conditions. The corporate profit outlook looks good. You’ve had resilient profits, profit levels, a steady-ish economy that does not seem to be overheating. And as a result, the Federal Reserve feels now it does not have the impetus to raise interest rates more. Once you combine a relatively low default rate for corporate bonds, this is a historically fertile ground for the high-yield market to produce good returns.
The problem is that the upside in spreads is fairly low now. Spreads are relatively thin. They’re at the lower end of history. Spreads being the excess yield that high-yield bonds have to risk-free bonds like treasuries, these are relatively low versus historical averages. So, we tend to think that the pricing of high-yield bonds is relatively in line with the excellent conditions of corporate profitability right now.
CEFA:
Are you finding valuations for convertibles and high yield to be at attractive levels?
Tony Huang:
Some of the elements that go into convertible valuations are attractive. As I mentioned before, the pricing of volatility is lower now, and that shows up in the levels of the VIX. Also, the underlying equities of the convertible universe, they have more of a tilt towards mid and small cap equities than the S&P 500, which is what many investors use as the basic measure of equities. There are large, mid and small cap issuers of convertibles.
And so mid and small cap equities have underperformed large caps over the last 12 months. To the extent that those would bounce back, the convertible market can perform with returns of a greater ratio of the S&P 500 than it typically has. High yield has thin spreads relative to history, and that may be for good reason though, given the level and the outlook on corporate profits.
CEFA:
Where are you seeing the best opportunities within the framework of the AVK strategy?
Tony Huang:
Well, as I mentioned earlier, Advent selects securities by focusing on company-specific fundamentals, so the portfolio will always be a collection of the individually vetted opportunities. Market conditions overall appear to be fruitful to allow the high level of corporate profits to continue, albeit with considerable volatility across sectors and regions. I think a research staff focused one by one on individual companies can ferret out enough opportunities to realize the total return that AVK shareholders are seeking.
CEFA:
How is AVK currently positioned?
Tony Huang:
Here are a few observations. First, the federal funds rate looks like it will be at or near 5% for some while. We do believe that the Federal Reserve will eventually be cutting rates, but they may not cut rates at a very steep pace, so we may have rates near 5% for some time or much of 2024.
We have kept an allocation to CLO securities. These are priced off the new Secured Overnight Financing Rate or SOFR, and will pay interest off that 5% with a spread on those individual securities. That leads to attractive current income for AVK.
Second, AVK’s international allocation has been creeping up, and that’s as a result of us finding more attractively priced convertibles in foreign markets, especially with foreign equities being broadly less expensive on earnings multiples than US equities.
And third, we continue to have the largest exposure among sectors to consumer discretionary. We see strong employment, pricing power in the leisure sector, and falling inflation is really helping corporate profits in many sectors, but consumer discretionary as well.
CEFA:
Tony, how do you see an allocation to an investment strategy like AVK best positioned in an investor’s diversified portfolio, and likewise, for an investor that is more income-oriented?
Tony Huang:
Convertible securities can provide an important diversifying element in a portfolio because they introduce a different asset class in that embedded equity option. Investors benefit more when the underlying equities do well and they suffer if the same underlying equities fall because the option delta falls and the security behaves more like a bond, where most of the time you get your par value back in maturity.
So that difference in behavior in up or down markets is unique to convertibles, and it’s what allowed the convertible asset class to have attractive Sharpe Ratios and risk-adjusted returns over time. Stated another way, the participation of the S&P’s gains has been higher in the up markets than the participation has been in the down markets, and that’s something that over a number of markets cycles has led convertible securities to have good risk-adjusted return ratios.
For the income investor, AVK has had an attractive and unchanged distribution for many years, and its exposure to some asset classes now generates good current yield from the high-yield bonds and CLO securities. So, we think that there can be a place for AVK for investors who are looking for both income as well as capital appreciation.
CEFA:
Tony, thank you so much for taking the time to join us today.
Tony Huang:
Thanks for having me.
CEFA:
And we want to thank you for tuning into another CEF Insights podcast.
