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Convertible CEFs: A Look Inside

Convertible securities are benefiting from an improving equity market.

Cara Esser, 06/07/2013

Improving equity markets have not only pushed equity securities higher, but convertible securities have also benefited. There are a number of closed-end funds, or CEFs, investing in convertible securities, many of which have performed well recently. Before delving into the funds and their unique risk/reward profiles, a brief review of convertible securities is in order.

Convertible Securities: The Basics
There are two types of convertible securities, convertible bonds and convertible preferred stock. Convertible bonds earn regular interest payments and include an option to convert the bond into shares of common stock. Convertible preferred stock also pay fixed coupons and usually have no maturity date (often called perpetual). These are also convertible into a firm's stock. Because the conversion option benefits investors, coupon payments will likely be lower than a similar nonconvertible bond but higher than a firm's dividend payout. From a firm's perspective, it's a balance of lower interest payments (good for equityholders) and a dilution of shares if bondholders convert (bad for equityholders).

A convertible bond has an issue price, face value, a set coupon payment, and a maturity date. At maturity, bonds can be redeemed at face value or converted at market value of the underlying shares based on the bond's conversion ratio (the number of shares per bond converted). Conversion ratios are also used to calculate certain valuation metrics for the bonds. For example, a bond with a $1,000 face value and a conversion ratio of 20:1 has a conversion price of $50 (1,000/20). If the firm's stock is trading at $40 per share, the conversion premium is $10 per share, or 25%. The bond's conversion value is $1,250. A convertible preferred pays a set interest payment and also has a conversion ratio, but usually has no maturity date.

Some convertible securities are callable by the issuer, which means the firm can repay the loan prior to maturity. This is often used to force conversion by bondholders when it is advantageous for the firm. A call feature usually increases the cost of the bond from the issuer's perspective (through a higher interest payment or lower issue price) because it is a drawback from the investor's perspective. Convertible bonds can also be putable by investors (an option to force payment by the issuer). Convertible securities can have varying options and features that make the bonds more or less attractive to investors.

From a risk perspective, convertible bonds have similar risks as nonconvertible bonds including interest-rate and default risk (many convertible bonds are rated below investment grade). From a volatility perspective, convertible bonds tend to behave like stocks as the price of the firm's common shares rise and behave more bondlike as the stock price falls. If a convertible security's price is more closely determined by the underlying equity price, then interest-rate risk is much lower. This means that, if interest rates rise, downward pressure on the bond's price will be much lower than a busted convertible. Convertibles are "busted" if the share price falls sharply below the conversion price. These securities, in effect, become like bonds, collecting coupons with little potential for conversion to stock. In general, convertible preferreds tend to be more volatile than convertible bonds because of the perpetual nature of the income payments.

Advocates of convertible securities tout the upside potential and downside protection inherent in the structure of the security (this is especially true for convertible bonds). John Calamos, a longtime convertible investment fund manager at Calamos Investments, aims to achieve 75% of the upside of equities with 25% of the downside in his convertible portfolios. Larry Keele, portfolio manager of Vanguard Convertible Securities VCVSX targets 65% to 90% of the upside and 30% to 50% of the downside. While this is an intriguing idea, the reality is much more uncertain. In general, investors can expect that convertible securities will be more volatile than plain-vanilla, investment-grade bonds and less volatile than stocks. However, this is not always true. During the 2008 market crash, convertible-bond funds offered little of the promised downside protection, many posting losses in line with the broader equity market decline. Although in 2009, the funds rebounded more quickly than equities. Risk measures that include the market crash have generally been much worse for convertible bonds than the broader equity and bond markets.

To be sure, six of the CEFs utilize leverage to a differing degree and the leverage in the funds hastened the fall off in net asset value during the crash and helped during the rebound in 2009. Leveraging any portfolio (even an investment-grade corporate-bond fund or a large-cap equity fund) adds volatility to total returns. Over the long term, however, the leverage has tended to be additive to total returns.

Convertible CEFs
Many of the convertible-focused CEFs also invest in high-yield bonds and one holds a meaningful allocation to common equities (Ellsworth Fund ECF). The table below lists the most recent portfolio allocation data for the nine CEFs in Morningstar's convertibles category. Most have a significant allocation to corporate bonds, many of which are junk bonds. The average credit quality of each fund's portfolio is below investment grade. 

Cara Esser is a closed-end fund analyst at Morningstar.

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