We know lots of financial advisors who use convertibles as part of a core allocation. At this point late in the market cycle, we’re also seeing heightened interest from investment professionals aware of convertible securities’ tactical value—to diversify fixed income especially now that volatility is picking up and rates are rising.
Below we check in with Joe Wysocki, Calamos Senior Vice President, Co-Portfolio Manager, including of Calamos Convertible Fund (CICVX), to hear more about the convertible bond market and the opportunities and risks he sees.
Q. Joe, you’ve been optimistic about convertibles all year. Are the performance drivers you identified in our May post (see The Drivers of Convertible Bonds’ Short and Long-Term Performance) still intact?
We think so. Individual companies ebb and flow over time but overall corporate fundamentals remain strong, balance sheets are in good shape. Many of the longer term growth drivers remain intact.
Volatility has returned this month, serving as a reminder that there are always risks to investing. But the key is not to avoid all risk, it is to be able to identify it and invest where the risk/reward tradeoff is in our favor.
We continue to find many convertible opportunities that enable us to build portfolios with good risk/reward profiles. We’re still finding ways to help us capture upside in the equity market while protecting on the downside.
Q. Convertibles’ strong performance through 9/30 attracted new advisors to the asset class. What do you want them to know? What can they expect?
We’re happy to see advisors discover the asset class, and we want it to perform in their clients’ portfolios as they’d expect.
Q. Sounds like there’s a “But…” coming?
We encourage advisors to use convertibles to focus on providing capital appreciation without jeopardizing capital preservation. Combining the capital appreciation potential of equities with the capital preservation characteristics of bonds can deliver benefits that each in isolation may not.
This is what’s at the core of Calamos’ 40-plus years of advocacy and enthusiasm for convertibles. However, combining equity and bond characteristics into one security creates some unique complexities. We know from experience the importance of active management in order to fully capitalize on convertibles’ advantages.
Q. What do advisors using passive strategies miss out on?
A. There’s less risk management—ironically, the very reason to consider convertibles.
It begins with portfolio composition. A passive strategy is based on a list of securities in an index, capital is not being allocated based on company fundamentals.
But more important is that the asset allocation decision is being effectively ignored. What happens when equities’ market value increases? The convertible equity sensitivity increases and equity-sensitive convertibles would potentially be larger positions in a passive strategy.
In the absence of rebalancing, investors could be holding an equity portfolio (such as in 2000) or, conversely, could be holding a straight bond portfolio (as in 2008) at the exact wrong time.
I was asked recently whether convertibles have moved too far, too fast.
The discipline in our process involves constantly monitoring these relationships and making adjustments to align with our top-down and bottom-up analysis.
Let’s use technology as an example. Tech is an area where a number of the underlying equities have been quite strong this year and the equity sensitivity of the convertibles has increased—this exposes an investor to downside risk if the equity reverses. (Also see Using Convertibles to Manage Technology Risk.)
We have been very active in monitoring these risks and rebalancing back toward more balanced profiles where we think the risk/reward tradeoff is again tilted in our favor. This continuous rebalancing helps us participate in the capital appreciation of the equity while moving up our bond floor to preserve capital should the equity correct.
Q. The S&P 500 fell almost 5.5% at the start of the month only to climb back. What happens, Joe, when a market downturn is more long-lived and severe?
A. Due in part to their hybrid nature, convertibles—and CICVX in particular—have historically performed well relative to an all-equity portfolio during equity market corrections.
A recent example was earlier this year when the S&P plunged 10% late January through early February, and our risk-managed approach and active management helped us cushion the downside and be exposed to just 60% of the decline.
At the same time, convertibles have done quite well in periods of rising rates, which tend to be difficult for straight bond portfolios. This is due to the equity component that enables convertibles to participate in equity upside, which has historically happened later in economic cycles when the Fed is raising rates. (Also see How Equity Alternatives Have Performed When Rates Rose.)
But I do like to remind advisors that the short-term drivers of convertibles primarily depend on the performance of the underlying companies. Therefore, each market correction can be different based on the composition of the market and the source of the decline.
Understanding these exposures and having the expertise to analyze both equity and credit fundamentals is vital. Further, when you step back and view convertibles over the long term through full market cycles you can see that—despite all the short-term ups and downs in the market over the past 20 years—they have delivered equity market returns with lower downside volatility. That’s what makes them a valuable addition to any asset allocation.
Q. Last month was the 10-year anniversary of the Great Financial Crisis. Can we ask you to reminisce about that period? What did you take away from that experience?
A. I don’t think there is any substitute for the first-hand experience one gains from investing through turbulent markets such as 2008-2009.
While the drawdowns were steep, our approach to convertibles held up significantly better than the equity market with a peak-to-trough decline of -30% vs. -55% for the S&P, and bested the overall convert market of -42% for the ICE BofAML All U.S. Convertibles Index (VXA0).
By holding up better and rebalancing risk, Calamos Convertible Fund was able to fully recover by early 2010. That was two years ahead of the broader equity market.
In the years since, declines in the broad equity market have been few, far between and relatively shallow. In the absence of volatility, higher risk strategies have outperformed and maybe memories have dimmed. What I’ll never forget—and hope that people never take for granted—is the value of actively managing risk.
For more on convertibles, register for “Convertibles in Portfolio Construction: A Master Class for Today,” an October 31 Webcast featuring Wysocki along with Calamos Founder, Chairman and Global CIO John P. Calamos, Sr., and Eli Pars, Co-CIO, Head of Alternative Strategies and Co-Head of Convertible Strategies, Senior Co-Portfolio Manager, including of the Calamos Market Neutral Income Fund (CMNIX).
Or talk to a Calamos Investment Consultant at 888-571-2567 or email email@example.com.