Q: How are you positioned in convertibles?
Convertible Market Overview
Convertible securities delivered a strong first quarter of 2006, the result of two key drivers: While convertibles benefited from the ongoing rally of their underlying equity counterparts, additional positive performance came from broader recognition of their lower valuations relative to stocks. We thus saw the asset class begin to close the valuation gap which had widened over the course of 2005. We believe there are additional opportunities for returns throughout 2006, as equities show continued strength and the valuation gap, although narrower, remains.
Over several previous quarters, we've been making the case for a constructive economy and the importance of focusing on securities with equity sensitivity. As we see the markets reaching new highs, it's clear that we've been positioned correctly. Convertibles demonstrated the benefits of their propensity to track the performance of their underlying stocks in the first quarter of 2006, as the markets showed further recognition of the strong economic backdrop typical of the middle phase of the growth cycle. The convertible market (measured by VXA0) provided strong returns for the first quarter, rising 5.32%. The majority of this return came in the first month of the quarter, with February being basically flat and March modestly positive. Performance was positive for the convertible universe across all 10 economic sectors. Materials and Telecommunication Services, while relatively small sectors, delivered the strongest performance during the period.
Credit spreads narrowed during the quarter, indicating the market's relative comfort with the health of the economy. Following the full year 2005 when investment grade issues outperformed speculative grade issues, the investment grade universe lagged the speculative grade universe by a fairly large margin in the first quarter of 2006. The differential between them was significant: The investment-grade universe (measured by the Merrill Lynch All Investment-Grade U.S. Convertibles Index VXA18) was up 2.44% for the quarter, while the speculative grade universe (measured by the Merrill Lynch All Speculative-Grade U.S. Convertibles Index VXA29) was up 7.43%. Convertible issuance, while still relatively light, has improved over the year earlier period. New convertible issuance for the first quarter was $11.5 billion; however redemptions outpaced this level of issuance creating a net redemption of $6.3 billion in the first quarter.
Outlook/Positioning
As we noted above, the economy continues to perform well which is consistent with our view that we are in the mid-cycle growth phase of the economy. The portfolio is biased toward higher-quality issues that offer good equity sensitivity. These issues should benefit from the current economic backdrop of stable growth. This greater equity sensitivity helped the portfolio during the first three months of the year, and should continue to benefit the portfolio as underlying equities increase in value.
Furthermore, valuations remain compelling within the convertible universe, as we have begun to see a closing of the valuation gap: Throughout 2005, convertible valuations were under pressure from hedge fund selling activity and a lack of volatility in the market. This pressure on valuations created an excellent opportunity for convertible bond holders, and we have been positioning the portfolio to benefit from a return to more normal historic ranges for convertible valuations. During the first quarter, convertible bond valuations have begun to improve, helping performance and closing some of the valuation gap. We believe convertible valuations will improve further and return to more normal historical valuation levels. The portfolio remains positioned to take further advantage of this valuation opportunity by investing assets in securities that offer the most attractive risk/reward characteristics. As the economy continues to demonstrate its resiliency and the Fed winds down its tightening phase, we anticipate a strong equity market, which, in turn, should support additional gains within the convertible universe.
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Index Definitions:
1 The S&P 500 Index is an unmanaged index generally considered representative of the U.S. stock market.
2 Russell 2000® Index measures the performance of the 2,000 smallest companies in the Russell 3000 Index, which represents approximately 8% of the total market capitalization of the Russell 3000 Index. As of the latest reconstitution, the average market capitalization was approximately $664.9 million; the median market capitalization was approximately $539.5 million. The largest company in the index had an approximate market capitalization of $1.8 billion.
3 Russell Midcap® Index measures the performance of the 800 smallest companies in the Russell 1000 Index, which represent approximately 25% of the total market capitalization of the Russell 1000 Index. As of the latest reconstitution, the average market capitalization was approximately $4.7 billion; the median market capitalization was approximately $3.6 billion. The largest company in the index had an approximate market capitalization of $13.7 billion.
4 Russell 1000® Value Index measures the performance of those Russell 1000 companies with lower price-to-book ratios and lower forecasted growth values. The Russell 1000® Index measures the performance of the 1,000 largest companies in the Russell 3000 Index, which represents approximately 92% of the total market capitalization of the Russell 3000 Index.
5 Russell 1000® Growth Index measures the performance of those Russell 1000 companies with higher price-to-book ratios and higher forecasted growth values. The Russell 1000® Index measures the performance of the 1,000 largest companies in the Russell 3000 Index, which represents approximately 92% of the total market capitalization of the Russell 3000 Index.
6 The CSFB High Yield Index is an unmanaged index of high yield debt securities.
7 The Merrill Lynch All U.S. Convertibles Index (VXA0) is comprised of approximately 500 issues of convertible bonds and preferred stock of all qualities.
8 The Merrill Lynch All Investment Grade Convertible Index (VXA1) is comprised of approximately 200 issues of only investment-grade convertible bonds and preferreds.
9 The Merrill Lynch All Speculative Grade Convertible Index (VXA2) is comprised of approximately 300 issues of only speculative-grade convertible bonds and preferreds.
Index returns assume reinvestment of dividends and, unlike Fund returns, do not reflect any fees or expenses. It is not possible to invest directly into an index.
Performance data quoted represents past performance which is no guarantee of future results. Current performance may be lower or higher than the performance quoted.
The views and opinions expressed by John P. Calamos and Nick P. Calamos are as of the date of the article, and are subject to change at any time based upon market or other conditions. The material contained herein is for informational purposes only and should not be considered investment advice.
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