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| The Basics | How convertibles help one manager thrive
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Calamos Convertibles Fund keeps beating the market soundly. A key piece to building wealth, its manager says, is controlling risk. Here's how he does it.
By Timothy Middleton
Back in 1987, investment legend Warren Buffett bought a huge stake in Salomon Brothers that was hedged with an almost no-lose codicil: What he actually bought was convertible preferred stock that paid 9% interest while he waited for the common to rise from its then-current level of $32 to its strike price of $38.
Disaster struck: Salomon became embroiled in a bond-trading scandal from which Buffett, as the firms biggest investor, emerged as chairman and savior. By 1997, Salomon was attractive enough to be bought by Travelers Group, itself later acquired by Citigroup (C, news, msgs). Buffetts investment roughly doubled.
A double in a decade is a minor-league, single-digit, annual return. But the interest, or coupon, on the preferred stock ended up being worth more than stock-price appreciation, transforming it into another of Buffetts famous successes.
Convertible securities are still much better known by experts such as Buffett than by small investors. They allow investors to buy a bond or preferred stock, then exchange it for a set amount of common stock. Investors not only earn interest on the bond or preferred shares, they can reap the gains on a rise in the common stock, too. Institutions dominate the $500 billion industry, in which the United States has replaced Japan as the world leader. Among them is a family of mutual funds run by Calamos Investments of suburban Chicago.
The companys chief investment officer, John Calamos, has been doing this for more than 20 years, and hes written the book on it, says William Harding, the Morningstar analyst who covers the funds. He means that literally: Calamos has written two books, Convertible Securities and Investing in Convertible Securities.
This is the shops bread and butter, and theyve done a great job of it, Harding says.
Its taken a bear market to dramatize how great that job has been. The companys flagship fund, Calamos Convertible (CCVIX), in 2002 moved up from the second-performance decile among its peers over the previous 10 years to the first. Its slightly more aggressive sibling, Calamos Convertibles Growth & Income (CVTRX), ranked among the top 1% of funds of its type.
Building wealth in the long term depends on risk control, we believe, Calamos says. We really look at ourselves not so much as a convertibles manager, but as a risk manager participating in equity markets in a defensive manner.
Playing both sides
Because they can be converted into common stock, converts are more like an equity investment than a bond, but theyre a lot more like a bond than a share of common stock. This hybrid nature leads to a security that pays less interest than a straight bond, but offers substantial gains if the common stock prospers.
One example: General Motors (GM, news, msgs) sold a rash of convertible bonds, and Calamos was a buyer of one tranche of notes that pays 4.5% interest and are convertible into GM common stock at a price 23% above where it was when the issue was sold.
The premium means you have 80% of the upside opportunity of the common stock, Calamos says. To figure the potential equity gains, the premium is subtracted from 100%. But the downside is extremely low -- about 10%, he figures, because the bonds coupon is already substantially below the market rate, which averages 6.5% for investment-grade issues, and therefore wouldnt have as far to fall if rates were to rise.
The dual nature of the securities is revealed in the performance of Calamos Convertible. When the bull market was at its peak, in 1999, the fund surged 35.1%, beating even the S&P 500 ($INX) by 14 percentage points. When the bear market began, one year later, the fund managed a positive return of 7.1%, beating the market by 16.2 percentage points. The fund has also done significantly better than the overall market for converts.
Shifting targets
Calamos uses stock-screening software to winnow down the vast amount of information available about public companies, then deploys his army of 30 investment professionals to narrow the target list down to 100 names. In essence, the company has to do two equally difficult jobs: assess a companys creditworthiness, as well as the unique nature of individual securities, as any bond investor would; and assess the outlook for its common stock, as an equity investor would.
Convertibles are harder to analyze than straightforward bonds because the interplay between the coupon and the convertibility strike price is different on every issue. So is the term of the bond and the convertibility features. Often, companies can call the bonds in specified time periods that reduce their potential upside. Calamos has a host of proprietary software models that help determine when converts are priced fairly or inefficiently.
Converts also come in the form of preferred stock, which isnt as safe as a bond, but typically pays a much higher dividend than common stock. Calamos buys preferreds as well as bonds.
The firm is always fully invested, so it controls risk by diversifying thoroughly and balancing lower-quality credits with those of higher quality. We want the total portfolio to look like that GM bond, says Calamos. We want 75% to 80% of the upside and no more than 20% to 25% of downside risk.
To maintain that profile through a market cycle, Calamos tends to be constantly selling off its winners and buying issues with lower relative prices. The underlying assumption is that markets are volatile and will go up and down, says Calamos, who is also co-manager of the companys funds. We cant predict any short-term volatility, but we can maintain that risk-reward ratio relatively constant. (The other managers of the companys funds are Calamoss nephew, Nick, and his son, John Jr.)
Good risk reduction
Another of the companys funds, Calamos High Yield (CHYDX), invests in junk bonds and in so-called busted converts. These are the bonds or preferred of companies whose financial fortunes have gone south, and the strike price for convertibility is far higher than the shares are likely to fetch anytime soon.
As good as it is with bonds, Calamos is an exceptional equity investor. Calamos Growth Fund (CVGRX) ranks in the top tier similar funds for the last 10 years, according to Morningstar.
Calamos is a medium-sized money manager, with about $10 billion under management; costs are reasonable, with A-share loads at 4.75% and fund expense ratios of around 1.45%, the average for convertible funds.
Investors shifting to fixed-income funds from their formerly high-flying tech portfolios run two risks. The first is that interest rates will rise, pushing bond prices down. The second is that a new bull market will erupt and deliver returns that leave bonds in the dust.
Convertibles diminish these risks. If the economy revives, stock prices boom and interest rates rise, their equity attributes will more than make up for their bond losses. If the opposite happens, moreover, their bond features will deliver an attractive yield even if the equity potential is low.
Thats pretty close to having your cake and eating it, too.
At the time of original publication, Timothy Middleton didnt own any of the securities mentioned in this article.
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