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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. 

  - source: Morningstar Analysts

In general, these funds' managers have the freedom to allocate (within a range) to either convertible securities, corporate bonds, or stocks based on current valuations and projections about future risk/reward scenarios. Although we've grouped all convertibles with synthetic convertibles, most funds do not create synthetic convertibles and those that do (Calamos, in particular) do so in small amounts. 

Risk & Returns
The table below shows total returns for the one-, three-, five-, and 10-year periods, discount or premium, leverage ratio, and distribution rate for the nine convertible CEFs, the CEF average, the mutual fund average, and the SPDR S&P 500 SPY and SPDR Barclays Aggregate Bond LAG for broad trend comparison. The CEFs, as a group, have outperformed the mutual fund category average over all time periods displayed and the distribution rates are much higher.

  - source: Morningstar Analysts

Distribution rates of the CEFs vary widely; the highest is from AllianzGI Convertible & Income NCZ at 12.3%. This fund generally holds a 50/50 combination of high-yield bonds and convertible securities and has a relatively high leverage ratio. The fund's returns have been good, but volatile. Over the past 10 years, Calamos Convertible Opportunities & Income CHI and Calamos Convertible & High Income CHY are the best performers, up more than 9% on an annualized basis. Of the nine funds in the group, these two funds are our favorites and both have earned Morningstar Analyst Ratings of Bronze. Calamos is generally a conservative shop as seen in the relatively low leverage ratios and modest distribution rates.

Leverage ratios vary, and this has caused wide divergence in risk statistics as shown in the table below. Because many of the funds tout an ability to capture a percentage of the overall equity market movements, the up and down capture ratios are calculated against the S&P 500 Index.

  - source: Morningstar Analysts

Against the index, the Calamos funds generally have the smallest downside capture ratios over three, five, and 10 years (meaning when the market was down, these funds lost less than both the market and peers), but they also have relatively low upside capture ratios. The historical capture ratios, however, are near John Calamos' target of 75% of the upside and 25% of the downside of the overall market, though the downside capture ratios for periods including 2008 (about 60% over five and 10 years) are much worse than this target. Keep in mind that the leverage used in the funds likely account for some of the mismatch to Calamos' broad statement about his firm's strategy employed across many fund vehicles.

Highly leveraged Advent Claymore Convertible Securities & Income AGC has scary downside capture ratios of 130 for both three and five years. This means that the fund lost more than the market as it was falling. So much for downside protection! What's more, the fund's upside capture ratios have been mediocre, and certainly not enough to compensate for the volatility on the downside. Ellsworth Fund has surprisingly stable historical upside and downside capture ratios over each time period. (This fund is unleveraged.)

As with any asset class, investors need to dig into performance and volatility of total returns before allocating to nontraditional securities. The risk profile of a convertible security sounds appealing, but real-world performance shows divergent risk/return profiles between the nine CEFs investing in the securities. But, for investors looking for a vehicle with a steady income payment and the ability to capture some of the equity market's upside movements, a convertible fund may be appropriate as a niche holding on their portfolio.

Click here for data and commentary on individual closed-end funds. 

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

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