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Publication for private investors November 2015 FocusPoint In-depth insights from NN Investment Partners Convertible bonds offer investors equity-like returns with a risk profile comparable to that of bonds. Convertible bonds: the fixed-income alternative to equities • Convertible bonds have outperformed other asset classes in the past 40 years, profiting from equity and bond bull markets. • Asset class’s expected returns are comparable to equities, with lower volatility. • Rate of default among issuers of convertibles is lower than high-yield bonds. Convertible bonds carry risks similar to other fixed-income investments. Bonds with lower credit ratings are subject to greater market, credit and default risk. www.nnip.com FocusPoint November 2015 The fixed-income alternative to equities Convertible bonds Convertible bonds form a well-established asset class that has outperformed through the cycle during the last 40 years. Convertibles have displayed lower volatility than equities and fewer defaults than high-yield bonds. The key attraction of the investment class is its potential ability to generate returns from both rising equity and credit markets. NN Investment Partners’ convertibles investment strategy seeks to capture the essence of the opportunities offered by the convertible market. Our strategy is global, focused on balanced convertibles, supported by in-depth credit research and concentrated on a select number of convertibles that combine solid credit fundamentals, underlying equity upside and a balanced convertible profile with acceptable if not attractive valuations. Background The first convertible bonds were issued in the 1850s by U.S. companies seeking to finance construction of the country’s nascent rail industry. Since then, the market for convertible bonds has developed into a unique niche in the investment asset market, with the value of outstanding convertibles growing to about US$380 billion as of the end of 2014. Their chief attraction – safe principal with potentially unlimited upside – has remained fundamentally unchanged since their conception 165 years ago. The value of the bond at issuance can be seen as a theoretical mix of the bond element and the option. Once issued, convertible bonds trade in a relatively liquid secondary market (US$1.4 billion traded daily). Prices are determined by their theoretical value and demand/supply factors. An explanation of convertible bonds Historic convertible performance versus equities Convertible bonds are corporate bonds that may be exchanged by the holder for a fixed number of ordinary shares. They can be regarded as a combination of a fixed income instrument and a stock option, with the bond limiting downside risk and the option providing equity return participation. Convertibles are designed to increase in value alongside equities in rising markets, while being protected from the inevitable sharp declines. The value of the underlying bond provides a “floor” value for convertible bonds and prevents prices falling with equities past a certain level. These instruments are a unique and useful tool in the investor’s portfolio. In today’s low-yielding environment, their potential relative return and diversification benefits make them especially attractive in light of the lower expected returns of bonds and the uncertainty of equities. Convertibles have historically performed well compared with equities, with a level of volatility that makes their efficiency, as measured by risk and return, comparable to that of bonds. They also compete with high yield with similar expected return/volatility characteristics. Convertible and high-yield bonds also supplement each other with diversification benefits. Investments in both asset classes can reduce risk and/or improve expected returns of high yield investments. Investors who are seeking better returns through high yield, but are concerned about the risk involved, might consider adding convertibles. Figure 1 shows a comparison of the performances of US investment grade bonds, high-yield bonds, convertible bonds and equities from 1973 through 1998. The 1972 values of each class have been set at 100; their ensuing performances are tracked in relation to the 1972 base point. For example, a 1% return for a given asset class in the first year would put it at 101 while a 5% loss would put it at 95. As with all corporate bonds, convertibles are subject to the risk of default, i.e., the risk that the issuer will be unable to make timely interest payments or repay the principle when the bond expires. An issuer’s credit rating can give an indication of the likelihood of default. As is the case with all fixed-income investments, the market value of a convertible can decline when interest rates rise. Figure 1: US asset classes’ total returns (1972 = 100) 4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 0 72 74 Convertibles 76 78 S&P 500 80 82 84 86 88 90 IG Govt/Corp Bonds 92 94 96 98 HY Bonds Source: Bloomberg, BofA Merrill Lynch Indices (1973-1998) Equities, as measured by the S&P 500 index, were the clear driver of growth in asset prices in this period, far ahead of all fixed income. Convertibles still managed to follow closely, capturing 75% of equity performance. 2 November 2015 In the subsequent period, from 1999 through to 2014, the equity market suffered two severe downturns and was overall a much more volatile environment. During this time span, fixed income performed quite well, thanks to declines in interest rates and a limited number of corporate defaults. Convertibles were able to benefit through their bond element and significantly outperformed equities. Figure 2, which re-bases the values of all the asset classes at 100 in 1998, illustrates this trend. Credit selection supported by in-depth credit analysis Our process is based on the belief that credit fundamentals are essential in providing capital preservation and asymmetric returns. We believe that these issuers with solid balance sheets and attractive business prospects can be better singled out by in-depth credit and business analysis than by reliance on rating-agency notations. Our portfolio of convertibles at the end of June 2015 consisted of about 10% investment grade convertibles. The average credit spread of our convertible portfolio is in line with the broader convertible universe. Figure 2: US asset classes’ total returns (1998 = 100) 350 300 Non-investment grade bonds have lower credit ratings and generally pay higher yields than investment grade securities but are subject to greater market, credit and default risk. 250 200 While the credit quality of a particular security of group of securities does not ensure the stability or safety of an overall portfolio, we believe that a sound approach to convertible bond investing includes limiting equity premium while selecting the convertibles that provide the highest possible equity sensitivity in order to grab the highest possible equity upside. 150 100 50 98 99 00 01 02 03 04 05 06 07 08 09 10 11 Convertibles S&P 500 IG Govt/Corp Bonds 12 13 14 HY Bonds Source: Bloomberg, BofA Merrill Lynch Indices (1998-2014) Theme-based approach On top of this ability to “piggy-back” on the bull markets of both asset classes during different periods, the volatility of global convertibles – a measure of a security’s risk – has on average been only about 45% of that of equities. NN IP’s convertible bond investment philosophy and process At NN Investment Partners, we manage an investment strategy in convertibles that we believe captures the essence of the opportunities offered by the convertible market through an established four-step process. In the first step we scan the investable universe for convexity – our strategy is global and focused on balanced convertibles. Our security selection in steps two and three is supported by in-depth credit research and theme-based equity selection. In step four we apply rigorous risk control in constructing the portfolio. In order to identify the catalysts that may unlock equity value within the investment horizon, we favour a theme-based approach in selecting the underlying equities of our investments. A “theme” is a set of common catalysts for underlying equities; these themes may relate to sectors, regions or macro-economic, micro-economic, or societal considerations. The companies that belong to a common theme are likely to react to common identified catalysts. All our investments are selected for their fit in a chosen theme. At any point in time, we deploy our investments into 10 to 15 themes. Figure 3 plots our theme selection in terms of weight, equity premium and equity sensitivity at the end of January 2015. We believe that our process, managed by an experienced convertible team and designed after thorough analysis of the convertible market characteristics and investors’ demands, can optimally deliver equity participation with downside protection and contained volatility. Figure 3: NN IP Convertible Strategy Themes 90% US Consumer Growth Equity Sensitivity 80% Real Estate Exposure 70% 60% Online Spending Growth Bank Deleveraging 50% Healthcare Spending Japan QE Demographic Transition Europe Rebound 40% 30% Global Aging Cloud Computing 20% Oil Services Spending 10% Cash 5% 10% 15% 20% 25% 30% 35% Equity Risk Source: NN IP (February 2015) 3 FocusPoint Disclaimer The elements contained in this document have been prepared solely for the purpose of information and do not constitute an offer, in particular a prospectus or any invitation to treat, buy or sell any security or to participate in any trading strategy. Investors should seek their own advice if in doubt about the suitability of any investment. While particular attention has been paid to the contents of this document, no guarantee, warranty or representation, express or implied, is given to the accuracy, correctness or completeness thereof. Any information given in this document may be subject to change or update without notice. Neither NN Investment Partners Holdings N.V. nor any other company or unit belonging to the NN Group, nor any of its officers, directors or employees can be held directly or indirectly liable or responsible with respect to the information and/or November 2015 recommendations of any kind expressed herein. Investment sustains risks. Please note that the value of your investment may rise or fall and also that past performance is not indicative of future results and shall in no event be deemed as such. This document and information contained herein must not be copied, reproduced, distributed or passed to any person at any time without our prior written consent. Any claims arising out of or in connection with the terms and conditions of this disclaimer are governed by Dutch law. This document is not intended and may not be used to solicit sales of investments or subscription of securities in countries where this is prohibited by the relevant authorities or legislation. 4