The portfolio management team of Calamos Convertible Fund (CICVX) opened the Calamos February CIO Conference Call series last week acknowledging that convertibles have recently provided less participation to the S&P 500 than would typically be expected.
With almost 50 years of experience between them, Senior Co-Portfolio Managers Jon Vacko and Joe Wysocki described today’s market as in a state of flux: Mid- to small cap issuers are struggling more than S&P companies, and the convertible bonds’ historical performance advantage when rates rise has yet to materialize. What’s helpful, they said, is that the record issuance of the last two years has broadened the opportunity set, providing the team with ample room to manage for a favorable risk-reward in this increasingly volatile market. (Listen to the call in its entirety here.)
Today’s macro uncertainty is “making volatility the norm. But the volatility, the rotations we’re seeing, and the diversions from the S&P are not concerning. We’ve been here before,” said Wysocki.
“Convertibles can act differently at different times, whether it’s months or quarters or even longer than typical as we’ve seen this year but,” he said, “through cycles, convertibles have produced broader equity market-like returns with less volatility. We don’t see anything structural that can change that longer-term relationship today.
“If anything [the current environment has] created some good opportunities for us to take advantage of,” he said. Consolidation in some of the issuer base of convertibles due to recent market rotations can set the stage for further returns going forward, he added.
The convertible market is dynamic and that’s especially apparent today, said Vacko. “Deltas are at the lowest level since pre-COVID, and we have more busted bonds than we’ve seen in a long time. You’d have to go back to March of 2020 to see a similar level of busted bonds. Fifty percent of bonds today are at or below par.”
Because any attempt to time rotations is “futile,” according to Vacko, the team believes the key is to focus on maintaining a favorable structural risk-reward. “There are times when we say we roll up deltas and times when we roll down delta,” he said.
He contrasted the value of the fund’s active management—backed by a full team of equity and credit analysts—to what happens with a passive convertible fund. Investors in passive convertible products today will “likely not know if you’re getting exposure to an equity portfolio or a busted portfolio or a balanced portfolio.”
Having focused on shielding shareholders in the fourth quarter from the downside risk of some growth names, Vacko said the team has since been surprised by the magnitude of the move in some of those names.
“We think they may have overshot, and risks at this point might have shifted to missing on the upside,” according to Vacko. “We’re picking and choosing our spots to play offense right now. We’re evaluating what companies are saying and what they’re doing, and we’re looking at who’s winning…For the most part, we like what we hear so far [in earnings calls]. This very bottom-up, individual company-driven performance focus is exactly the same kind of thing that helped returns in 2020. It’s the same process that we’ve used through all our cycles.”
Vacko provided these specifics:
Fundamentals. The fundamental momentum of many issuers is “very strong. We’re looking at accelerations in revenue, in cash flow, improving margins or positive analyst revisions. We’ve seen companies able to overcome some supply chain issues, etc., and those are the types of names we’re looking to add. In general, the companies that we’re looking at are well capitalized, and generally have decent balance sheets.“Often, in the convertible universe, convertible bonds are the only debt on the issuers’ balance sheets, and they still have a lot of the cash remaining on their balance sheets from convert issuance. So, the overall credit risk is minimal within our universe and within our portfolio.”
Valuations. Some individual names are becoming very attractive from a valuation perspective. “Our process focuses on intrinsic value and growth of that intrinsic value over time. In some instances, we’re seeing that the intrinsic value has grown, if we compare it to pre-COVID levels, but the stock prices are at the same level or down. That can be a great opportunity for us.”The analysis is on revenue generation and whether improvements are sustainable or just a result of having been brought forward during COVID. The same is happening on the expense side. “Many companies had to cut expenses through the recession, and some will be able to maintain those, and some will have to add those costs back to get back to where they were,” Vacko explained.
Vacko and Wysocki commented on the broader opportunity set available in the convertible market.
Both 2021 and 2020 are in the top five years of convertible issuance—resulting in more than 100 more companies in the market than two years ago. “That’s not an insignificant number,” Wysocki noted, “because our market has about 400 companies on the US side that issue convertibles.”
What’s more, many of the companies have multiple convertibles within their capital structures, providing more bonds to choose from.
“No two bonds are the same,” Wysocki said. “Even if the same company issues a convertible, the terms can be different, and the actual price points at which they were issued could be different, and as we know, convertibles are hybrid securities that can act like debt or equity, depending on where the market’s moved since issuance.”
The team regularly swaps positions within a company’s individual convertible offering in pursuit of what they believe is the best risk-reward.
Some of today’s volatility can be attributed to investor uncertainty about rising rates. Wysocki took time on the call to review why convertibles have historically outperformed fixed income when interest rates rise.
When rates rise, a traditional bond portfolio tends to have negative total returns. It’s a mathematical relationship, Wysocki explained, where when rates are up, bond prices are down, the income you receive from that bond does not offset the capital loss, and that results in a negative total return.
Here’s the advantage that convertibles have historically provided: When the 10-year Treasury has risen by 100 basis points or more, traditional bond allocations have had negative returns while convertibles have produced positive returns, beating the equity markets in some cases.
“The driver of those returns with convertibles is not a mathematical relationship like it is with traditional bonds,” Wysocki explained, “but you can understand how that works when you look at the hybrid nature of convertibles.
“Convertibles have a bond portion and an equity option. That bond portion faces the same headwinds that traditional bonds do. When interest rates rise, that bond portion is worth less. But they are shorter duration bonds—five years when issued—so typically you have a convertible duration that is much lower than any of the other fixed income markets (see this post). That can help mitigate the risk of the downside.
“On the flipside," he continued, "the equity option can benefit from rising equity prices, and typically, when rates are rising, it’s because of a stronger economy or rising inflation. Stocks can benefit from that as well, from rising revenues, rising profits, rising cash flows. Companies can have pricing power to take advantage of some of that.”
The equity participation embedded within the convertible more than offsets the downside from the bond portion of it, resulting in equity-like returns with less equity risk. (For more on convertibles, see our guide.)
“Each rate cycle is different, so it’s important to understand what drives a rising rates cycle. But," Wysocki said, "that volatility can be a bit different as it starts. While there’s uncertainty as to why rates are rising, convertibles may have more volatility and variability at the beginning of a rates cycle, but as it progresses, convertibles have been able to do quite well.”
Investment professionals, for more information about CICVX or convertibles, contact your Calamos Investment Consultant at 888-571-2567 or email@example.com.
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The principal risks of investing in the Calamos Convertible Fund include: convertible securities risk consisting of the potential for a decline in value during periods of rising interest rates and the risk of the borrower to miss payments, synthetic convertible instruments risk consisting of fluctuations inconsistent with a convertible security and the risk of components expiring worthless, foreign securities risk, equity securities risk, interest rate risk, credit risk, high yield risk, portfolio selection risk and liquidity risk. As a result of political or economic instability in foreign countries, there can be special risks associated with investing in foreign securities, including fluctuations in currency exchange rates, increased price volatility and difficulty obtaining information. In addition, emerging markets may present additional risk due to potential for greater economic and political instability in less developed countries.
The S&P 500 Index is generally considered representative of the US stock market.
The 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.
Delta expresses the convertible's sensitivity to changes in the stock price. It compares the amount of change in the price of a convertible with the change in the underlying stock price.