Specialists discuss holistic to fundamental approaches

How do seasoned investors evaluate which convertible bonds they want to buy?

Michael Miller, the Wellesley, Mass.-based president and chief investment officer of convertible bond specialist Wellesley Asset Management Inc., said that while some bond managers may evaluate convertible bonds solely by studying the underlying stock, he takes a more “holistic approach.”

“We first screen out unprofitable companies on both a GAAP and non-GAAP basis and eliminate companies with extremely levered balance sheets as defined by debt-to-equity ratio,” Mr. Miller said.

“We then review valuation metrics, focusing on current and forward price-to-earnings, price-to-earnings-to-growth ratios and enterprise value. Once we have a list of companies that meet our criteria, we complete due diligence on the credit profile of the company and review the specifics of the convertible such as the delta, conversion premium, yield to maturity, price and valuation.”

This is an “iterative process” Mr. Miller added, in which Wellesley portfolio managers review bonds on a daily basis.

George J. Cipolloni III, Philadelphia-based portfolio manager at fixed-income specialist Penn Mutual Asset Management, said he primarily evaluates every convertible or non-convertible bond, by studying underlying companies’ long-term fundamentals.

“Specific to convertible bonds, we believe it is incredibly important to understand the underlying stock, its potential upside and downside, its credit quality and other indicators of value,” Mr. Cipolloni said.

Mr. Miller said he is currently avoiding “high-flying” companies with high price valuations that don’t have a “consistent history of earnings growth.”

“We are particularly bearish on many of the names” in the Bank of America Merrill Lynch All U.S. Convertibles index, “as numerous bonds are trading significantly above par with a high sensitivity to their underlying equity,” Mr. Miller said. “If we continue to see volatility in the markets, these names could be hit particularly hard.”

Tracy V. Maitland, New York-based president and CIO of alternative credit firm Advent Capital Management LLC, said he generally avoids investing in convertibles “where we see deteriorating credit profiles.”

Some convertibles that Advent currently owns and is bullish on include Southwest Airlines Co. (“investment-grade balance sheet, company had capital to reinvest in the business during the COVID-19 downturn,” Mr. Maitland said); Royal Caribbean Cruises Ltd. (“best-in-class operator in a space where we believe there is significant pent-up demand and healthy consumer balance sheets,” he noted); and software firm Splunk Inc. (“which is set to generate significant cash and return to midteens free cash-flow margin by 2023,” Mr. Maitland said.)