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Creating a Synthetic Convertible Bond

Christine Benz

Christine Benz: Now I want to switch over to convertibles, that's obviously been a key asset class for your firm over the years. I'd like you to discuss the supply situation within the convertibles market. I know that you and your colleagues there have increasingly turned to what you call synthetic converts. So, let's first discuss that supply issue and then talk about what a synthetic convertible is and how you construct one?

Nick Calamos: The supply situation is relatively difficult right now. The main reason is that the economy is not growing rapidly; the European economy is not growing rapidly. And the economies that are growing rapidly, emerging economies, are not big issuers of debt. The debt markets there have not yet grown up to the point that we would like them to.

That's changing quickly, though. We're going to see a lot more high yield. We're going to see a lot more convertible issuance, and quite frankly, corporate insurance and high-grade issuance out of the emerging economies. I would guess during the next five years, it's going to be the place to be.

But at this point it's very, very slow. In the United States, we're seeing issuance. They tend to be small issues, and unfortunately for the most part the redemption rate in convertibles is higher than the new-issuance rate. So, the marketplace is actually still shrinking, and that's the same thing in Europe. At one point, Japan was the largest convertibles market in the world, and now it's probably one tenth of the size it was.

Convertibles are typically issued by growth companies; its growth capital that they need. If you're not growing, there is no need for capital, and therefore the market tends to shrink.

We have utilized synthetic convertibles. The way that we structure a synthetic convertible is that the convertible can be looked at as a fixed income vehicle with a long-term option attached to it. So we go into the marketplace and find the companies that we like, the equities, and purchase the underlying options if they are priced appropriately, if they are cheap. Then we will mirror that typically with either the same debt corresponding to the option or something different depending on our comfort level.

In many cases today, we have bonds from Brazil, Norway, and Singapore, just all these sovereign bonds of hard-currency countries or commodity-currency countries that we are comfortable with that are the fixed-income component of that synthetic convertible. If we are right, hopefully the fixed-income portion appreciates and also that the equity option portion really increases in value. So we're creating a synthetic convertible.

Our objective is to have the income flow from the fixed income pay off that option over time. The low-interest-rate environment has made that a little bit hard, so they are not quite as attractive as they were maybe seven, 10, or 15 years ago, but they are still more attractive than a lot of the current convertibles in the market place.

Benz: How much of your big open-end convertibles fund would you say these synthetic converts compose?

Calamos: We also do not only synthetics but also structured notes, and those are similar. We would go to the big investment banks and say "We're looking for a convertible. This is the equity we want; this is the credit rating we want. Structure this." We will price it with three of four different firms to get the best price we can, and the low price wins. The problem with that is you end up with a lot of the credit in the financial side of the sectors that we don't want right now. So our exposure there is very limited. We have a little bit exposure, but not a lot.

Historically, we would go up to 10% in structured and maybe as much another 5%-10% in synthetics. So it could be  up to 20% of our portfolios. Today we are about half of that because the structured side doesn't make any sense. We would have too much financial exposure in our portfolio.