ACV - ACV: Finally Starting To Look Attractive

2023-10-05 13:29:33 ET

Summary

• Virtus Diversified Income & Convertible Fund specializes in convertible bonds to generate high-yield income for investors.
• Convertible bonds offer the benefit of participating in stock upside while still providing the safety of bonds but they offer lower yields in exchange.
• The fund is set to outperform when tech stocks are doing well and underperform when tech stocks are lagging.
• The current NAV discount makes it at least worth a look.

Virtus Diversified Income & Convertible Fund ( ACV ) is a bond fund that specialized is convertible bonds in order to generate high-yield income for investors. After peaking at the end of 2021 and selling off for 2 years, the fund is finally approaching a price range where it might make sense to start building a position for long-term oriented investors who want to boost their income.

First, what are convertible bonds? They are a subset of the corporate bond universe. They are different from regular bonds because they usually convert to common stock after a company's stock price rises to a pre-agreed value. These can be win-win for both issuing companies and investing institutions. Notice that I said "institutions" because it's very rare for retail investors to be able to buy these bonds due to them having large minimum investment requirements. How are these win-win for both parties? It allows companies to be able to borrow cash at low interest rates while allowing investors to participate upside in stock while enjoying safety of bonds at the same time.

Since convertible bonds can convert to stock at an agreed upon price, the investors of these bonds will benefit from upside in common stock as if they are holding an options contract. Meanwhile, they are still holding a bond so the risk of losing their money is minimal. Let's say an institution buys convertible bonds for Company A whose stock currently trades at $80 and these convert to stock if Company A's share price passes $100. If Company A's stock climbs above $100, the investors holding the bond participate in upside and make a profit. If Company A's stock remains below $100, investors don't get to participate in upside but they still have to get paid because it's still a bond with obligations. The initial investment doesn't go away no matter what unless the company goes bankrupt and the bankruptcy court decides to wipe out its bond obligations which is super rare.

If it's a win-win situation, what's the catch? After all there is no such thing as risk-free or caveat-free investment. For the company issuing these bonds the biggest catch is that their stock can suffer dilution. When convertible bonds convert into stock, new shares have to be created which will dilute the value of existing shares. Also, if the company is paying dividends, now it has to pay dividends on more shares which could affect their cash flow situation.

For the investor of convertible bonds, the biggest catch is that they have to accept much lower interest rates for the benefit of being able to participate in stock upside. A company's regular corporate bonds could yield 7-8% while the same company's convertible bonds could yield only 2-3%. Investors of convertible bonds are accepting lower rates in exchange for upside potential without taking a risk in the stock and suffering downside.

Now let us look at ACV's holdings. We are seeing that the fund currently holds 313 positions. Interestingly enough not all the fund's positions are bonds. Notice that it has shares in Alphabet (GOOGL) ( GOOG ), Microsoft ( MSFT ) and Apple ( AAPL ). It's not uncommon for convertible bond funds to hold common stock because their convertible shares may convert into stocks. Some funds will sell their bonds as soon as they convert into shares and book their profit while others will hold those stocks for a while if they see upside. As much as I know, Apple and Microsoft don't have convertible bonds since they have a credit rating of AAA so they can command very low rates as it is. It looks like the fund actually bought those shares. Now, when we look at some of the fund's convertible bond holdings we see Zillow (Z) 2.75% bonds and Liberty 3.125% bonds. These companies don't have the best credit ratings and it would be very difficult if not impossible for these companies to have such low rates if they were issuing regular debt instead of convertible debt.

Which brings us to our next discussion. The types of companies that typically issue convertible bonds are going to be either start-ups, turnaround stories, companies who don't have as much access to liquidity or companies with weak credit ratings. This is why it is common for many of these convertible bonds to be called "junk bonds" but not all are. Just a few years ago Tesla ( TSLA ) was making use of convertible bonds to raise cash cheaply. Sometimes great companies use these when they want to get access to cheap credit but it's rare for a company with AAA or AA rating to make use of them. It looks like ACV tries to balance it out by keeping shares of companies like Apple and Microsoft which have very strong credit ratings.

Currently the fund sells for a NAV discount of 5.14%. Earlier this year the fund's NAV discount was approaching 10% but the gap seems to be closing now. Since convertible bonds correlate strongly with the performance of the stock market, you will see a wider discount when stocks are on sale and there is panic in the streets as compared to when the market is in a rallying mode. Historically this fund should trade at a price very close to its NAV and discounts like what you are seeing today aren't very common.

The fund was created in 2015 and it has been around for less than a decade. When we look at the fund's performance, it resulted in total returns of 87% since inception. This looks impressive but notice that the fund's total return was approaching 200% by late 2021 right before last year's bear market started. This shows you that convertible bond funds can perform really well if stock markets perform well but their performance will lag if stocks start underperforming. What we've been seeing since early 2022 is what I would call a double-whammy because both stocks and bonds got hit hard at the same time which is historically very rare. Typically bonds tend to outperform when stocks underperform because people run to safety of bonds but it hasn't happened last year so this fund got hit twice when both stock and bond prices dropped significantly at once. It's been recovering though so we will have to wait and see.

The fund pays a rich dividend yield of 12%. Most of the dividends come from capital gains which makes sense because most of the bonds held by the company yield less than 5% and most of its stock holdings yield 1% or less. The fund has shown some dividend growth in its history but it's been more driven by outperformance of the stock market than anything else.

Tech companies tend to issue convertible bonds far more than any other sector so this fund's exposure is going to be overweight in tech stocks. The fund's overall performance and ability to distribute any gains will depend on how well tech stocks perform so you can consider investing into this fund more like an investment in Nasdaq rather than the overall stock market. Investors should be comfortable with the fact that tech stocks tend to be more volatile but also keep in mind that convertible bonds participate in upside but not downside in stock movements so your volatility will be more limited in nature unless we have a bond bear market coupled with a stock bear market which is very rare, but then again we just had one last year.

I think this fund is now worth a look especially if you are bullish in tech stocks overall. If you are feeling bearish about stocks in general, this might not be the fund for you though.

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