Market volatility, as measured by the VIX Index, has risen more than 100% over the past seven months. During volatile periods like this one, convertible bonds can truly demonstrate the benefits of their hybrid nature: rising when the equity markets go up, and providing a cushion on the downside when equities drop. Furthermore, escalating volatility can mean greater value in the conversion feature (or optionality) of convertible bonds.
As of the end of July, in fact, the U.S. convertible market outperformed the broad equity and high-yield markets for the year-to-date period.
| Year-to-Date Returns through 7/31/07 |
| Convertibles |
4.40% |
| Stocks |
3.64% |
| High Yield |
-0.18% |
Convertible issuance has been quite strong in 2007. Through the end of July, new issues had raised $58.9 billion, almost 60% more than the amount raised in the first seven months of 2006. Although redemptions remain high, they total $45 billion year to date, resulting in positive net new issuance for the first time since 2003.i
According to our proprietary model, the convertible market is currently 0.55% undervalued. Although this is within the range that the market typically trades in, we believe valuations are still attractive at this level, and we continue to find good opportunities in the convertible marketplace.
Outlook
We expect the increased equity and debt market volatility to continue as the subprime shakeout ripples through the economy and nervous investors react precipitously to daily news and forecasts. For several months, we've expected a shift in the market favoring higher quality, more stable assets; so the current conditions have played well into our positioning.
Indeed, although speculative-grade convertibles have outperformed for some time now, we're beginning to see the turn favoring investment-grade convertibles that we've been expecting. We were encouraged to see the sharp outperformance of investment-grade issues during July.
Reflecting our bias toward less cyclical sectors, we are generally favoring consumer growth and health care, while marginally decreasing allocations to financials. Within cyclical areas of the market, we have found opportunities in international infrastructure and engineering-related companies. We have also maintained overweighted allocations to information technology.
We continue to favor growth companies over value companies; to us, the earnings slowdown and relative valuation differences favor growth securities. When one adjusts for quality and capital access risk, large- and mid-cap companies look more attractive than smaller-cap issues. We also have continued to overweight companies with strong balance sheets and higher credit quality relative to the market benchmarks.
Past performance is no guarantee of future results. Current performance may be lower or higher than the performance quoted.
Index Definitions
The VIX Index measures expectations of near-term volatility conveyed by S&P 500 stock index option prices. The VIX Index is generally considered to be a barometer of investor sentiment and equity market volatility.
The U.S. convertible market is represented by the Merrill Lynch All U.S. Convertible Index (VXA0), which is comprised of approximately 700 issues of only convertible bonds and preferreds of all qualities. The high-yield market is represented by the Merrill Lynch High Yield Master II Index (H0A0), which is an unmanaged index consisting of U.S. dollar denominated bonds that are issued in countries having a BBB3 or higher debt rating with at least one year remaining till maturity. All bonds must have a credit rating below investment grade but not in default. The stock market is represented by the S&P 500 Stock Index, an unmanaged index generally considered representative of the domestic large-cap stock market.
There are certain risks associated with an investment in a convertible bond such as default risk—that the company issuing a convertible security may be unable to repay principal and interest—and interest rate risk—that the convertible may decrease in value if interest rates increase.
Unmanaged index returns assume reinvestment of any and all distributions and do not reflect fees, expenses or sales charges. Investors cannot invest directly in an index.
iSource: Merrill Lynch
This commentary is presented for informational purposes only and should not be considered investment advice.
Calamos Advisors LLC
7369