Q. The Fed continued to be a focus of investors. How did Fed actions influence closed-end funds?
A. Rising short-term interest rates were the big story through the first half of 2006. Many closed-end funds use leverage by borrowing funds at very short-term rates. As short-term interest rates rise, this increases the cost of leverage and can impact the yield and total return of a fund. While the Calamos closed-end funds do employ leverage in the form of preferred shares, a majority of the cost of leverage was locked in for longer periods earlier in the interest rate cycle for the three oldest funds, when rates were lower. Because the cost of leverage was locked in at longer-term fixed rates, these portfolios were not significantly affected by the rising short-term interest rates that marked 2005 and the first half of 2006.
Interest Rates
January 2004 - December 2006
Q. How did long-term interest rates affect closed-end funds?
A. Long-term interest rates also rose over the first half of 2006, with the yield on the 10-year Treasury moving from 4.37% at the beginning of the 2006 to 5.15% in June 2006 before declining to finish the year at 4.71%. Rising long-term interest rates tend to negatively affect high-quality fixed-income securities. The Calamos portfolios include high-yield corporate bonds and convertible bonds that tend to be more economically sensitive and much less interest-rate sensitive. This was demonstrated over the period as the portfolio benefited from continued economic growth and a general rise in the equity market.
Q. What other major developments occurred with the economy and markets in 2006?
Mid-cycle slowdowns are typically characterized by a number of factors, most of which are present today:
- An end to Fed rate hikes
- Moderation of energy prices
- Slowing in the housing market
- Increasing market volatility
- Moderation of consumer spending
- Declining commodity prices
Historically, mid-cycle slowdowns have been accompanied by a shift in market leadership from cyclical investments to growth-oriented investments. Across the Calamos funds, we are favoring companies we believe have good prospects for sustainable growth and reduced sensitivity to the economy. Our investment discipline and outlook have led us to a number of traditional large-cap growth companies trading at prices we believe are very attractive relative to the broad market and historical values.
A. In 2006, we began to conclude that the economy—while fundamentally sound—was entering a mid-cycle slowdown phase. By the end of 2006, we believe this outlook was confirmed. Growth in gross domestic product was respectable, albeit more tempered than it was during the recovery phase in the preceding years. Corporate earnings were strong overall, and balance sheets solid. Merger-and-acquisition and private capital trends were favorable as well. Consumer spending lost some steam, but shows no signs of stopping; declining gasoline prices in the fourth quarter, along with increased wages, provided an additional boost to consumers—and the markets. Inflation concerns cast a persistent shadow, but in the end, core inflation remained quite tame. Unemployment continues to be low. Although the yield curve had inverted, liquidity and credit remained ample. The housing market descended from its stratospheric heights but did not fall below a reasonable level; in fact, it showed signs of stabilizing during the fourth quarter.
Using history as a framework for our current thinking, we believe this mid-cycle slowdown will resemble those of 1965, 1985-86 and 1995. Each of those periods was preceded by U.S. Fed tightening that seemed to be either early or directed at excess building in the markets. In each case, the market was a leading indicator, reacting to the slowdown before the gross domestic product (GDP) reflected it; and in each case, we saw a solid upswing in the markets in the midst of mid-cycle economic slowdowns.
After a challenging second quarter, the markets gained a degree of traction by the end of September, and major stock indexes around the globe posted solid gains for the third and fourth quarters of 2006. Convertible and high-yield securities participated in the equity market upside during the period, earning respectable gains as well.
Global economic growth provided continued support for the international markets; gains in both developed and emerging markets surpassed the healthy return of the U.S. market. Among developed markets, Japan continued to show signs of economic improvement, including gross domestic product growth, easing deflationary pressures and increasing retail trends. In developed Europe, economic growth was better than many expected. Germany, for example, saw improvements in employment, business and consumer data. Moreover, interest rate increases by the European Central Bank and a strengthening euro did not dampen market sentiment; corporate restructurings also bolstered confidence. In the emerging markets, expanding economic freedoms, greater stability, and corporate innovations provided an ongoing catalyst; India serves as a prime example. A less favorable environment persisted in much of Latin America, with governments such as Venezuela's moving to curtail economic and trade freedoms.
One significant change that occurred in past mid-cycle slowdowns was a shift from a pro-cyclical market to a more growth-oriented market. The portfolio's emphasis on higher-quality sustainable growth names and reduction in the cyclical sectors positions it well for a rotation in market leadership to stable growth.