In its quest to provide attractive, risk-adjusted performance, the Equity Income fund relies on convertible securities to dampen the volatility of its returns and help limit downside risk. The portfolio has held convertibles since its August 1994 inception. While the fund has no set asset target for its convertibles, the historical range has been 15% to 30% of the portfolio’s assets. As of February 28, Equity Income had 24% of its assets in convertible securities.

Here are some frequently asked questions we receive on Equity Income’s use of convertibles:

What exactly are convertible securities?

As their name implies, convertible securities—normally convertible bonds or convertible preferred stock—can be converted into a different security at the holder’s request, typically to a specific number of shares of a company’s common stock. The “conversion ratio” is determined at the time of issuance.

Convertible bonds pay income but are paid off with stock (instead of cash) at maturity. Convertible preferred is preferred stock that can be converted into common stock. It pays a steady income stream in the form of a set dividend. At times, Equity Income also invests in what are commonly called “synthetic” convertibles. These are convertible securities created by financial institutions such as Merrill Lynch or Goldman Sachs. These institutions do so at our request when a company Equity Income is interested in does not have a convertible security in its capital structure. Synthetics are designed to replicate corporate convertible securities, with pre-defined conversion terms and conditions.

Why does Equity Income invest in convertible securities?

Convertibles play a central role in Equity Income’s risk-averse investment strategy by performing two important functions: They enhance the portfolio’s yield while providing explicit downside protection.

Convertibles represent a conservative way to approach the stock market. By their nature, these securities combine the characteristics of bonds and stocks, providing competitive current yields, plus the capital appreciation potential associated with equities. While convertibles normally benefit from price increases in the company’s underlying stock, their bond-like attributes help dampen the effects of stock-price declines. At the same time, the portfolio retains the ability to participate in the company’s common shares if they move up over time.

As lower-risk investments, a company’s convertible bond or convertible preferred stock will usually have less upside potential than its common shares. Investors seeking risk-adjusted returns over time are willing to exchange some of that appreciation potential for a greater degree of downside protection.

Convertibles: A Main Ingredient in Risk-Adjusted Returns

This Manager Risk/Return chart measures the life-of-portfolio performance for Equity Income, relative to risk. The chart also illustrates the performance-protection relationship inherent in convertible securities.

How does the Equity Income investment team go about finding attractive convertible securities?

Portfolio managers Phil Davidson, Kevin Toney, and Michael Liss search for high-quality businesses first; the decision to invest in a company’s convertible securities comes later.

Equity Income’s investment process begins with a proprietary system of price filters to identify undervalued businesses. The investment team searches for value and quality across all sectors and industry groups on a bottom-up basis, selecting businesses one at a time that meet strict price requirements.

The heart of the process is what follows: stringent fundamental analysis—an examination of a company’s fundamentals, its competitive position, balance sheet, and returns over time. To the investment team, the most attractive portfolio candidates are quality companies with higher returns on capital, whether by having a better business, economies of scale, barriers to entry by competitors, or other advantages. They tend to be the leaders in their respective industries and well-capitalized, with business models that tend to generate recurring revenues, and thus a relatively steady cash flow stream.

Following this due diligence, the team can then decide whether to own a company’s common stock or its convertible securities (if they exist). In a recent interview with Financial Advisor magazine, Phil Davidson indicated that he favors owning convertible bonds when the underlying stock is reasonably priced or undervalued, when the company’s credit strength is stable or improving, and when the bond offers a higher yield than the common stock.

How did Equity Income’s convertibles perform in 2008?

The turmoil in the financial markets took a heavy toll on convertible securities last year. With common stocks hammered by one of the worst bear markets ever, returns of convertible securities followed suit. Additionally, fearful of unsettled credit markets, investors preferred the liquidity of U.S. Treasury securities, pushing down prices on corporate bonds in the process. The bankruptcy of Lehman Brothers Holdings, a large player in the convertibles market, sparked heavy selling. Hedge funds, forced to raise capital for redemptions, were also major sellers of convertibles.

As a result of all this, the Merrill Lynch Convertible Securities Index declined 33% during 2008. Meanwhile, thanks to its focus on quality, Equity Income’s complement of convertible bonds, which comprised the great majority of its convertible securities, was down 16%. Here are two examples of how high-quality convertibles performed for Equity Income during 2008:

Beckman Coulter. A top ten holding, Beckman is a leading provider of medical equipment. Its common shares fell 34.5%, while its convertible was down just 14.6%.

Intel Corp. The Equity Income investment team chose to invest in the volatile tech sector in a less-risky manner by owning the world leader in semiconductors. Intel’s common shares were down 31%; the chip maker’s convertible declined only 10%.

So far in 2009, Equity Income’s convertibles continue to provide protection on the downside:

Year-to-Date Through February 28:

Equity Income’s 21% average weighting in convertible bonds (as a group): -0.56%
S&P 500 Index: -18.62%
Russell 3000 Value Index: -23.56%

But Not All Convertibles Are Created Equal

While convertibles as a class have provided good returns over time, there can be landmines lurking in these investments as well. It takes sharp-pencil work on balance sheets and effective fundamental analysis to avoid convertibles that are overvalued or supported by weak balance sheets. One of many examples might be YRC Worldwide (formerly Yellow Roadway), the third-largest surface transportation company in the country.

Tonnage carried by YRC trucking companies like Yellow Transportation and Roadway Express has experienced a steep decline, due to the recession, and also because shippers have been concerned about the carrier’s deteriorating financial condition. (In February, the company had to forge a new credit agreement with its banks.) The carrier’s common stock and convertible bonds reflect that situation. YRC’s stock was down 84% for the year ended February 28, 2009. A YRC convertible bond paying 3.375% interest, that matures in 2023, didn’t provide much of a floor, either, declining 72.5%.

In Summary: When It Comes to Convertibles, Equity Income Wants the Best of the Best

• Since its inception, Equity Income has very successfully relied on convertible securities to smooth out its returns, enhance its yield, and provide a layer of downside protection. Historically, the best convertibles have been those tied to higher-quality companies whose underlying common stock has the potential to move higher.
• investment team regards convertibles underpinned by strong balance sheets as the most attractive investments, because they provide two advantages: a secure yield that helps collar downside risk, and a more likely opportunity to participate in a company’s common stock, if that moves up over time.

FOR INSTITUTIONAL USE ONLY/NOT FOR PUBLIC USE

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