It’s no time to be passive when the market is dropping 19% one quarter and then climbing back 8% the next month. Below Joe Wysocki, Calamos Senior Vice President, Co-Portfolio Manager including of Calamos Convertible Fund (CICVX), discusses some of the key decisions he and the team have been making.
“It was the best of times, it was the worst of times.”
I couldn’t help but think of the above quote given the recent market volatility. In two short months the news headlines have gone from “Dow, S&P Post Worst December Since 1932, Nasdaq Has Worst on Record” only to be followed by “The Best January in 30 Years.”
“Is this investing or is it gambling?” my father asked over the holidays.
One of the key advantages of convertibles is how we use them to manage through volatility—striving to capitalize on the opportunity that comes with it. Let’s review how converts handled this latest test that began just before the end of the fourth quarter of last year.
September Positioning Sought Downside Protection
The S&P 500 peaked on September 20, 2018 only to drop almost 20% by December 24, 2018, three months later.
As active managers, we often talk about the importance of monitoring market risks and rebalancing convertibles to assure that the portfolio maintains the optimal risk/reward tradeoff. That’s what we were doing during the summer months of ’18 when the market was hitting new highs (see this post for Wysocki’s comments on managing technology risk in August 2018). Our focus was on monitoring our rising equity sensitivity and credit quality while making sure that the portfolio was appropriately positioned against downside risk.
Changes made by September helped insulate investors in Calamos Convertible Fund (CICVX) for what was to come. CICVX’s halved the decline of the broader equity market.
Easing Back on the Defensiveness Ahead of January’s Recovery
Conditions flipped quickly, though, during the fourth quarter and this time we were facing an alternative scenario. Many convertibles had held up well relative to their underlying equities, but a new risk presented itself: Now the risk was that many convertibles had become more bond-like and potentially too defensive to generate a reasonable total return going forward.
One way to view this is by breaking down the convertible market as represented by the ICE BofAML All U.S. Convertibles Index (VXA0) into buckets based on the convertible characteristics.
As you can see, our sweet spot—the “total return” portion that provides the optimal combination of upside participation as well as downside protection—was still significant. But note how Yield Alternatives, the portion of the market that’s the most bond-like and has the least equity sensitivity, went from the least at 8/31/18 to the largest on 12/31/18. While still below the ~67% it represented during the depths of the financial crisis, this segment has rarely been above 40% over the past decade.
The volatility provided an opportunity for us to rebalance again. This time we were looking to exit more defensive or busted positions in favor of adding back more balanced convertibles at attractive prices that would provide more compelling total return profiles going forward.
Our ability to manage these tradeoffs and add to more favored names proved to be beneficial as the equity market subsequently rebounded 15% through January. The S&P posted a remarkable turnaround in just 38 days, but investors were still 7% below the September high.
CICVX was a mere 2.5% off September’s high—a much better outcome than most investors would have envisioned if they were only paying attention to the headlines during the volatility. The fund’s performance during this stretch, however, exemplifies what financial advisors look for when including CICVX in clients’ portfolios.
Convertibles Can Provide What Market Timing Can’t
In our experience in managing through many of these market cycles, our team has learned that one of the keys to success is to participate on the upside, but always have an eye toward protecting the downside. The larger the drawdown, the more is required to get back to break even, as we’ve discussed before (see Could Calamos Convertible Fund Help Reduce Your Retirees’ Worries?).
Convertible bonds have both equity and fixed income attributes, and this hybrid nature has historically proven to be a valuable tool in periods of volatility. Converts are able to participate in equity market upside while continuing to manage the downside. This is far preferred to trying to time market entrances and exits.
The two markets provide us with a fresh illustration of the case for including convertibles as a core part of any asset allocation. While we may not experience the same level of volatility in such a short period anytime soon, volatility is an ever-present risk—and opportunity.