Loomis Sayles high-yield funds run 15%-20% converts as "bond substitutes"

By Paul A. Harris

St. Louis, Mo., July 11 - Investment manager Loomis Sayles has accumulated billions of dollars of convertible securities for its fixed-income portfolios and currently has 15% to 20% of its high-yield funds invested in convertibles, according to Kathleen Gaffney, who compared them to "fallen angel" credits.

"For us they're essentially high yield substitutes," said Gaffney, vice president and portfolio manager. "We manage for total return.

"It's a slightly less efficient market, in general," she added. "Because it is a smaller market, the size of the issues tends to be a little bit smaller. But primarily the reason it tends to be inefficient is the makeup of the buyers - they tend to be more equity-oriented. There are fewer players like ourselves that have a fixed income perspective.

"So generally when we get interested is when the stock declines, and everybody who is equity oriented and has owned the convert suddenly realizes they own a bond, which they tend not to want to own. So they sell. It's equivalent to a fallen angel coming out of the equity world going into the bond world. So it trades down in price and up in yield and at that point becomes a credit decision."

Gaffney said that Loomis Sayles tends to focus on busted converts.

"They're essentially bond substitutes," she said. "The option to convert to equities becomes meaningless because the stocks are down.

"The convertible market has been a very interesting on over the past few years," she added. "If you go back five years the market was dominated by institutional investors like ourselves, and only 25% by hedge funds.

"These days the hedge funds are the major players. They probably make up 75% of the market right now. And outright convertible investors are the minority at 25%.

"The hedge funds are playing on the volatility in the underlying common stocks and looking at the value on the option on the convert. Because the hedge funds have grown so dramatically in size and they're such a big player, there has been a lot of high-quality issuance in the convertible market. And that's helping to broaden the investor base."

Gaffney added that in the past when convertibles would bust up they would fall to very low levels in order to entice fixed-income players into the market.

"Now the hedge fund players will tend to support a market so it will never get as cheap as it used to because they're looking at the yield and they can buy it before it gets to a real busted level and still short the common," Gaffney added.

"They're not as concerned with the overall credit but are looking for a way to hedge their returns."

Gaffney said Loomis Sayles currently owns about $3 billion in busted converts. The high-yield funds are probably running 15%-20%, she said, and the medium-grade accounts, which are allowed to use some high yield, are running 12%-15%.

"We're opportunistic users," she said. "That's kind of a low range for us, right now. When the equity markets were very cheap some of our high yield funds got as high as 40% converts.

"It's an asset class that can be very cheap. But that generally happens when stocks are really washed out."

Given the present circumstances in the capital markets, Gaffney added, investors may want to pay closer attention to convertibles.

"Given that you have had a lot of new issuance in a lot of the high quality investment-grade names, if large cap stocks really start to crater you're going to have a lot of opportunity," she commented. "Right now they're not as attractive but I think there is going to be a tremendous opportunity down the road.

"The other side of that is that the hedge funds, being the dominant player, are going to get squeezed once interest rates start to rise. The yield advantage won't be as attractive to them and they'll start selling their converts.

"So I think we could get some really attractive buying opportunities at some point down the road - in the next 12-18 months."

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