Equity Market Resets Provide Opportunities for Rebalancing Risk/Reward

Jon Vacko, CFA, and Joe Wysocki, CFA

• CICVX continues to emphasize balanced convertibles that offer attractive levels of upside participation and potential downside risk mitigation.
• We’ve found opportunities to invest in convertibles with more pronounced bond characteristics; these offer attractive yields, compelling structures, and the potential to benefit from spread compression.
• Holdings include issuers positioned to benefit from secular growth themes, in areas such as cybersecurity, automation, and productivity enhancement.

Market volatility continued through the first quarter as the United States and Europe experienced notable banking stresses while continuing to raise interest rates to combat persistently high inflation. Slowing economic growth will likely linger through tighter lending standards and higher capital cost, contributing to heightened uncertainty and recessionary probabilities. However, provided the hot US job market can be cooled but not derailed and further banking dislocations can be contained, a recession is not imminent. With inflation peaking, supply chains normalizing, a resilient consumer, and a Federal Reserve close to ending rate hikes, a bullish case remains for equities—and convertible securities.

Given the macro backdrop, our focus continues to be on actively managing the risk/reward tradeoffs within Calamos Convertible Fund (CICVX). As we have discussed in the past, the characteristics of convertible securities vary. Some are more bond-like, some are more equity-like and others offer a balance. To take advantage of equity valuation resets, we have maintained a preference for the balanced portion of the convertible market. Balanced convertibles provide a favorable asymmetric payoff profile by offering attractive levels of upside equity participation with less exposure to downside moves. We also see opportunities within the bond-like segment of the convertible market in issues that can benefit from spread compression while offering attractive yields and good structural risk mitigation from further equity market weakness. Within this segment of the convertible market, most issuers retain strong cash balances along with minimal near-term refinancing risk. We are avoiding the group’s most distressed names.

Global Convertible Fund Allocations

Technology and health care remain the largest sector allocations in CICVX. Reflecting our strong focus on bottom-up company analysis, we favor companies that are executing well despite macro uncertainties; those that are best-in-class; and long-term winners benefiting from lasting secular themes such as cybersecurity, automation, and productivity enhancement. These long-term themes serve as a beacon in turbulent times such as now and help us identify innovative firms whose valuations are most likely to be rewarded over time. Many of these are growth firms that have shifted focus from growth at all costs to improving margins, generating free cash flow and increasing profitability, which should prove advantageous as higher quality growth becomes scarce as the era of free money ends. Financials and REITs are the largest relative underweight in the fund. In our view, the risk/reward characteristics in this space are generally unfavorable, and many issuers are susceptible to the negative impact of higher rates. Also, in our view, the financial names in CICVX do not share the same deposit risk seen in other currently stressed financials.

Convertible new issuance was subdued in 2022 but has improved in 2023 with higher coupons and lower conversion premiums that are more favorable to investors. For the first quarter of 2023, global convertible issuance totaled $19.7 billion, more than double the $7.9 billion issued during the first quarter of 2022. We are optimistic about issuance prospects going forward. We believe the pace will accelerate once macro uncertainty subsides and as companies increasingly recognize the benefits of issuing lower-coupon convertibles rather than traditional bonds in an environment of higher interest rates.