InvestmentFront

Convertibles Reborn?

These Securities Have Existed Since the 1800s, but Many People are Only Beginning to Hear About Them, Thanks to Significant, Broad-Based Undervaluation and Certain Specific Characteristics.

By John P. Calamos Sr.

Stock prices could not have rebounded as they have in 2009 without a major shift in investors’ risk tolerance levels—from extreme caution in the second half of 2008, to greater risk appetite this year. Whether or not this continues is uncertain, and the stock market is historically a leading indicator. However, as the global economy begins to move out of recession, important headwinds remain in housing, employment, and consumers’ propensity to spend. We are convinced that an effective way to hedge this uncertain scenario is through convertibles.

Convertibles are hybrid securities that can potentially change from a bond into a stock, usually at a predetermined conversion price. The bond element offers typical fixed-income characteristics: a coupon and greater capital preservation potential. The conversion into stock unleashes potential benefits in a market rally. Thus, convertibles are a way to invest in the stock market with potentially less risk—while receiving a return prior to the conversion.

The Calamos convertible strategy has not only acted defensively (and provided strong absolute returns this year), but it has done so with less volatility than stocks. Due to these risk/reward characteristics we, at the Calamos organization, have always regarded our convertible strategy as a core risk control element in asset allocations for moderate-to-conservative investors. However, convertibles need not be confined to these investors. It is not the convertible security that makes a strategy work, but how it is used to achieve a specific investment objective. Convertible portfolios can be managed across the risk spectrum, from very aggressive to very conservative. Our emphasis is on how we manage the convertible portfolios, rather than on convertibles as an asset class.

If convertibles, however, have performed well—capping the potential for future upside—is there still opportunity to begin an allocation? It depends. If you are the type of investor that sought to benefit exclusively from the large price dislocations that drove this market to the lowest valuations in decades, you missed part of the excitement. The gap has closed fast, but not entirely. Based on Calamos proprietary valuations, we estimated that convertibles were trading at a 4.6% discount to theoretical fair value, as of July 31, 2009. This means that even if stocks do not rally, the valuation gap may continue to close, potentially providing a positive return. Reversion to fair value is unpredictable, but in prior cycles the process has taken several quarters, typically characterized by heightened market volatility.

Volatile markets that seem to lead nowhere, as in the late 70s and early 80s, can be excellent periods to manage the risk/reward element of convertibles, with one word of caution: quality. Triple C-rated convertibles have taken investors for a nice ride this year. We missed that ride on purpose. We are very leery of valuations that are not supported by the issuers’ underlying fundamentals and know well how quickly a relative return advantage, especially one based on lower-quality issues, may reverse itself in volatile markets. This brings us to a second type of investor.

If your goal is to mitigate risk over the longer term, your entry point into convertibles is broad and should not focus exclusively on the current undervaluation gap. As a firm, we have managed convertibles as a defensive equity strategy for more than 30 years, over which we have always found undervalued securities, whether or not the convertible universe as a whole has been undervalued.

All in all, wealth management is about balancing risk with opportunity. We have always believed, and continue to believe today, that a good way to seek that balance is through a disciplined, long-term and time-tested approach to convertible investing.


For comments or additional information please contact us at JPCsr@calamos.com, or 888.857.7604.


The opinions referenced are as of August 2009 and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Information contained herein is for informational purposes only and should not be considered investment advice. Past performance is no guarantee of future results. Please visit www.calamos.com for additional information regarding investment strategies, current performance and important risk information.

©2009 NEOCORP MEDIA

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