JPMorgan Global Convertibles Income Fund — Steady NAV progression and a 4.5% yield

JPMorgan Global Convertibles Income Fund (JGCI), launched in June 2013, is the only UK-listed closed-end investment company specialising in convertible bonds. It is incorporated in Guernsey and run by the convertible bonds team at J.P. Morgan Asset Management in London, with portfolio management responsibility shared between team head Antony Vallée, Robin Dunmall and Natalia Bucci. JGCI principally has an income focus, while the SICAV managed by the same team concentrates on balanced convertibles. There are three analysts on the team, providing global coverage across industry sectors, as well as a dedicated trading desk. The team’s broad market focus gives JGCI the flexibility to invest in the less bond-like segment in response to opportunities.

JGCI’s principal aim is to pay a regular quarterly income, although this may be sourced through income or capital returns. Gearing may be used tactically and the board has recently revised its discount control policy with the intention of reducing share price volatility.

Convertible bonds are essentially bonds with an embedded option allowing them to be converted into the underlying equity at a predetermined rate or by a particular date, normally at a premium to the share price at the time of issue. They typically pay a fixed income and can be redeemed at their par value if they are not converted. Convertibles are issued as bonds, typically with a yield lower than that available on ‘straight’ corporate bonds from the same issuer, but higher than the dividend yield on the underlying equity. Convertibles participate in the upside of the underlying equity, increasing in value as the share price rises, but also offer downside protection from the ‘bond floor’ (through the ability to redeem at par) if the share price goes down. Like a corporate bond, a convertible is exposed to default risk, and liquidity may be limited. However, the equity component reduces the sensitivity to interest rate movements.

Exhibit 2 illustrates the different segments of the convertible bond market, and shows the interaction of the bond and equity components at different share price levels. In the distressed segment, the convertible is trading below the bond floor, leading to a higher yield albeit with an increased risk of default. In the out-of-the-money segment, the convertible is most bond-like as the par value is above the price of the underlying equity, meaning there is no incentive to convert as the equity could be bought more cheaply in the open market. As the underlying share price rises, the value of the convertible also rises, meaning the yield goes down and there is more of a balance of capital and income returns. An in-the-money convertible is one where the price is above the par value of the bond, and will behave more like an equity.

JGCI Portfolio Manager Robin Dunmall comments that the team retains a positive view of the global economy, with limited near-term risk of a US recession and the European economy recovering strongly. Politically – while US President Trump does face some struggles implementing his reform agenda – a lot of the bigger risks have begun to resolve, with favourable outcomes in recent European elections, and Brexit negotiations looking increasingly like a domestic problem rather than an existential threat to the EU. This benign scenario provides support for equity markets even against a backdrop of generally high valuations, with bigger risks arguably coming from tight spreads on high-yield credit, and from longer-duration bonds given the possibility of further rate rises in the US and the beginning of monetary policy normalisation in Europe and the UK. These factors are feeding into JGCI’s current higher exposure to more equity-sensitive but short-dated securities, although Dunmall stresses that the yield focus remains the ‘heart and soul’ of the fund.

While security selection is bottom-up, Dunmall says the team is cognisant of how industry dynamics can affect issuers. He gives the example of real estate, where portfolio exposure has fallen because the sector looks less attractive in a rising interest rate environment. The team has reduced the allocation to bigger names in the sector, but retained exposure to issuers with specific catalysts, as well as UK real estate firms where yields have risen on fears over Brexit. Conversely, the stronger economic backdrop favours increased exposure to industrial and materials companies, although again the actual portfolio holdings are driven by bottom-up opportunities. Exposure to the oil sector has also increased, but Dunmall says this is in oil services companies – which benefit from any increase in production as oil prices rise – rather than the producers, whose upside is more limited.

Dunmall says the shift towards the balanced part of the market has also led the team to focus more on primary issuance. Convertibles held for yield are usually bought below par value in the secondary market. Year-to-date, there has been a strong primary market in the US, and the team has been active in participating where previously they would have considered the coupons on new issues too low.

As shown in Exhibit 2, the managers of JGCI view the convertible bond market as having three main segments, with the fund’s income focus meaning it tends to be more concentrated in the bond-like part of the market. Although the team is looking more at balanced convertibles in light of the greater focus on total returns, the managers say they are unlikely to buy non-yielding convertibles, except in cases where they redeem above par. The credit-sensitive (bond-like) part of the market is less favoured by the majority of convertible bond investors, and the team says this means they can buy selected bonds cheaply versus the theoretical value of the credit plus the equity optionality.

The global portfolio is constructed largely on a bottom-up basis, with sector allocation based partly on where the managers find the most compelling stock-specific opportunities, and partly on their assessment of prospects for yields and overall convertible bond market valuations. As well as evaluating the industry outlook, the managers undertake a detailed analysis of each issuer before investing. Securities are rarely held until maturity, with the team preferring to sell as convertibles approach parity with equity values, and reinvest the proceeds in higher-yielding names.

JGCI’s portfolio is broadly diversified by geography, industry, issuer size and credit quality. While many convertible bonds lack an official credit rating, all unrated securities are assessed and rated by the team, and the portfolio is tilted towards high-yield (BB and below) issuers. All currency exposures are hedged back to sterling, and derivatives may be used to reduce equity and duration risk. Portfolio turnover may be higher than for a conventional bond fund, particularly in rising stock markets, where convertible bonds may approach parity with equity valuations more quickly.

At 30 June 2017, there were 83 convertible bonds in the JGCI portfolio, a decrease from 106 a year previously. The top 30 positions made up 57% of the total portfolio by value. As shown in Exhibit 3 below, the portfolio is well spread by sector and geography. Over the past year, the sector breakdown has changed significantly, with a c 9pp increase in industrials exposure and c 5-6pp increases in energy and materials, while consumer cyclicals, communications, technology and real estate have fallen by between 2pp and 8pp.

Portfolio Manager Robin Dunmall says the portfolio has evolved in response to the opportunity set, as already low bond yields have fallen even further. At launch in 2013, it was possible to build a portfolio of bond-like convertibles with good yields, and more equity-sensitive (balanced) mid-cap issues with attractive coupons. However, falling yields made the balanced space less attractive for yield-focused investors, so the JGCI portfolio became increasingly bond-like. While the team was given additional flexibility to invest in lower-yielding securities in late 2015, a market dislocation meant there were good opportunities in the higher-yielding bond-like segment at that time, and Dunmall says the decision to remain invested in this area throughout 2016 was vindicated by JGCI’s performance versus the team’s SICAV fund, which focuses on the balanced part of the market.

Towards the end of 2016, the managers began to take advantage of the greater investment flexibility, taking positions in high-quality balanced convertibles trading close to the bond floor, which are short-dated so they have less duration risk, but are exposed to equity upside. The portfolio was defensively positioned as the managers felt equity markets were fully valued and yield spreads over corporate bonds were tight. Dunmall says there were conflicting arguments in the market at the time, with a supportive economic environment but high equity valuations meaning stock markets looked vulnerable to a correction. However, the election of Donald Trump as US president, bringing the possibility of fiscal stimulus to justify the market’s growth expectations, was a ‘shot of adrenaline’ that delayed any potential wobble or sell-off, and shielded markets from a period of high political risk due to factors such as the French elections and the UK’s Brexit negotiations. In light of this, the team adjusted the portfolio to bring in more balanced, equity-sensitive exposure, making the overall positioning of the fund more similar to how it was in its first two years.

All positions are added to the fund at positive yields. However, with greater equity sensitivity in the JGCI portfolio, Dunmall says that fixed income factors will be less significant this year than last, although yield will still be the fundamental driver of return.

JGCI has performed strongly in absolute terms over 12 months to 30 June 2017 (Exhibit 4). Notably for a global fund, this has not been boosted by the weak pound, because JGCI hedges its currency exposure back to sterling. Share price total returns have benefited from the introduction of a new approach to discount control in May 2017. NAV total returns are largely in line with the benchmark1 over most periods since inception, with a period of outperformance in late 2015/early 2016 as a result of the fund’s more conservative stance against an uncertain market backdrop.

As JGCI is essentially a bond fund, longer-term returns unsurprisingly look lacklustre versus the MSCI World Index (Exhibit 5). The managers point out that the underlying equity performance of the universe of convertible bonds with positive yields has also lagged the equity index over the period since JGCI’s launch, largely a result of equity index performance having been led by defensive mega-caps, rather than the growth-focused mid-caps that account for most convertible bond issuance. JGCI’s underlying equity performance has actually been ahead of the yielding convertibles universe.

Given JGCI’s short duration focus and mix of high-yield and investment-grade credits, there is no appropriate ‘straight’ bond index to compare it with; however, an analysis by the managers versus a composite of 75% short-dated high-yield and 25% three- to five-year investment grade corporate bonds shows the equity exposure of convertibles has provided a superior return over JGCI’s life.

JGCI traded at a premium to NAV for most of its first two years of life, but moved to a discount amid a sell-off in credit markets in the latter half of 2015. It remained at an appreciable discount throughout 2016 and into 2017, but since the new discount policy was put in place at the end of May, the discount has narrowed, and stood at 2.4% (based on cum-income NAV) at 27 July 2017. This is significantly narrower than the 6.8% average discount over one year, and also narrower than the 3.3% three-year average discount. Since launch in June 2013 the discount has averaged 1.6%.

JGCI is a closed-end investment company incorporated in Guernsey and listed on the London Stock Exchange. At 27 July 2017 it had 179.5m shares in issue, compared with 136.0m at launch in June 2013. Under the new discount policy, the fund will buy back or issue shares with the aim of maintaining the share price between a 2% discount and a 2% premium to NAV in normal market conditions. In the past 12 months, 15.7m shares (8.0% of shares outstanding at the start of the period) have been bought back at a cost of £15.4m, the vast majority in the two months since the new policy was announced in May 2017. The fund has a $32m borrowing facility with Scotiabank, recently renewed until 2 July 2018, of which $20m is currently drawn at an annual interest rate of 0.8% over Libor (FY16: $20m). The managers use gearing tactically and at 21 July 2017, net gearing stood at 5.5%. This was the same level as at end-H117, although in the intervening period it has been as high as 8.6% and as low as -2.2%. The maximum permitted level is 20% of net assets.

JPMorgan Funds receives an annual management fee of 0.75% of net assets, and there is no performance fee. At end-H117, ongoing charges were 0.91%.

When JGCI was launched in 2013, it was with the stated intention of paying a dividend of 4.5p per share (a 4.5% yield). This has been maintained in each subsequent year so far. Since FY15, dividends have been paid quarterly, in December, March, June and September. While the dividend was fully covered by income in the six months to 31 December 2016, the fund has the flexibility to fund the payout from capital as well as income, which may be necessary given the move to a more total return focus with a greater exposure to balanced convertibles. Three interim dividends of 1.125p have so far been paid for FY17, the same rate as in FY16. Revenue reserves increased from £64,000 at end-FY16 to £89,000 at end-H117. Based on the current share price, JGCI has a dividend yield (both historic and prospective) of 4.53%.

JGCI is the only UK-listed closed-end convertibles fund, and as such there is no directly comparable peer group. Exhibit 7 below draws together a group of funds that have an income focus and invest to some extent in convertibles. The Advent Claymore fund is a highly geared US-listed closed-end fund, while the Polar Capital and Salar funds are Irish-domiciled open-ended funds.

Within the group, JGCI has the second-highest NAV total return over both one and two years, and ranks third over three years. Over one and two years, NAV total returns are ahead of the two open-ended funds, which are more similar to JGCI from an investment perspective than the Advent Claymore fund. Ongoing charges are the lowest in the group, and there is no performance fee.

The very low level of gearing is again largely in line with the open-ended funds, which do not have the ability to gear. JGCI’s shares are trading close to NAV and its 4.5% dividend yield is in line with the median.

There are five non-executive directors on the board of JGCI, four of whom have been in place since the fund’s launch in 2013. Chairman Simon Miller is also the chairman of Brewin Dolphin Holdings and the North American Income Trust, and a director of STV Group. In line with JGCI’s constitutional commitment to have a majority of the board resident offshore, the other directors – Philip Taylor, Charlotte Valeur and Paul Meader – are based in the Channel Islands, as is Gailina J Liew, who was appointed in July 2017 having served as a board apprentice since November 2016. The directors’ professional backgrounds are in investment management, accountancy and business.