As a retiree, I am continually looking for sources of high income, but I also don't want to court excessive risk. This search led me to consider Convertibles Closed End Funds (CEFs). These funds offer excellent income (some with distributions more than 8%), but what about the associated risk? This article will analyze selected Convertibles CEFs in terms of their risk-to-reward characteristics.
A "convertible security" is an investment, usually a bond or preferred stock, that can be converted into a company's common stocks. A company will typically issue a convertible security to lower the cost of raising money. For example, many investors are willing to accept a lower payout because of the conversion feature.
The conversion formula is fixed and specifies the conditions that will allow the holder to convert into common stock. Therefore, the performance of a convertible is heavily influenced by the price action of the underlying stock. As the stock prices approaches or exceeds the "conversion price," the convertible tends to act more like an equity. If the stock price is far below the conversion price, the convertible acts more like a bond or preferred share.
Convertible CEFs usually contain a mixture of convertible securities and high yield bonds. The attraction of convertible CEFs is that they offer upside potential with some protection on the downside. Granted that with a portfolio of high yield bonds and convertibles, the downside protection is limited (as evidenced by severe losses in 2008). However, over the long run, the fund manager seeks to obtain the "sweet spot" between fixed income and equity that will enable him to outperform his peers.
Before jumping into the analysis of these CEFs, it may be instructive to review on how Return of Capital [ROC] should be interpreted for these funds. Return of capital has a bad connotation, because it is usually associated with a fund literally returning part of the capital you invested. This is bad and results in a decrease in Net Asset Value [NAV].
However, the exact definition of ROC depends on complex accounting and tax rules. For example, in a bull market, the fund manager may decide to not sell assets that have greatly appreciated, but instead use income that he has accumulated on his balance sheet to pay the distribution. In this case, part of the distribution may be labeled as ROC, but it is not destructive. My rule of thumb is that ROC is not destructive as long as the NAV continues to increase.
There are no CEF portfolios that are 100% convertible securities. All the portfolios have a mix of assets, but I have selected funds that have at least half of their assets in convertibles. In addition, I have required the funds to meet the following criteria.
- I wanted to analyze the CEFs over a complete bear and bull market cycle, so I chose only CEFs that had a history going back to 12 October 2007 (the start of the 2008 bear market).
- The CEFs had to be liquid, with an average trading volume of at least 50,000 shares per day
- The Market Capitalization had to be at least $200 million
- Return of Capital, if any, had to be non-destructive
The following 6 funds satisfied all of the selection criteria.
- AGIC Convertible and Income (NCV). This CEF sells for a premium of 6.9%, which is higher than its 52 week average premium of 4.5%. The fund has a portfolio of 120 holdings, consisting of 55% convertible securities and 42% high yield bonds. This price of this fund dropped 57% in 2008 but rebounded an amazing 143% in 2009. The fund utilizes 33% leverage and has an expense ratio of 1.3%. The distribution is a high 10.7%, which is received from income with no return of capital. Due to the high payout ratio, the fund tends to invest in lower quality securities that provide higher yield. This plus leverage tends to increase the volatility of this fund.
- AGIC Convertible and Income (NCZ). This CEF sells for a high premium of 13.3%, which is much higher than its average premium of 6.8%. The portfolio contains 119 holdings, consisting of 56% convertibles securities and 42% high yield bonds. This fund uses the same investment strategy as its sister fund NCZ, which results in an 89% correlations between the two funds. The price of this fund plummeted 61% in 2008 but rocketed 145% in 2009. The fund utilizes 33% leverage and has an expense ratio of 1.3%. The distribution is a high 10.5%, which is generated by income with no return of capital. As with its sister fund, NCZ has migrated to lower quality securities to maintain the high distribution.
- Calamos Convertible and High Yield (CHY). This fund sells at a discount of 6.3%, which is near is its average discount of 6.9%. The portfolio has 276 holding, consisting of 32% convertible bonds, 12% convertible preferred, 12% synthetic convertibles, and 42% high yield bonds. Synthetic convertibles are a way to construct a convertible-like asset by paring debt with call options on stocks. Securities are selected based on a combination of fundamental and quantitative research. The price of this fund only dropped 27% in 2008 and it rebounded 51% in 2009. The fund uses 28% leverage and has an expense ratio of 1.5%. The distribution is 7.4%, which consists of mostly income with some non-destructive return of capital. The fund tends to focus on higher quality convertibles that are selling near the conversion price, making this fund more equity-like.
- Calamos Convertible Opportunities and Income (CHI). This CEF sells for a premium of 1.3%, which is higher than its average discount of 1%. The portfolio has 277 holdings, consisting of 37% convertible bonds, 13% convertible preferred stock, 10% synthetic convertibles, and 39% high yield bonds. This fund uses the same investment strategy as its sister fund CHY, but the two funds are only 67 % correlated. The price of the fund dropped 35% in 2008 and rebounded 67% in 2009. The fund utilizes 28% leverage and has an expense ratio of 1.5%. The distribution is 8.1%, comprised of income and non-destructive return of capital. The fund's investment strategy is similar to that of its sister fund CHY.
- Advent Claymore Convertible and Income (AVK). This CEF sells for a discount of 9.8%, which is slightly lower than its average discount of 8.8%. The fund's portfolio has 314 holdings, consisting of 63% convertibles, 21% high yield bonds, and 14% equities. About 25% of the securities are from firms based outside of the United States. The fund uses 3 quantitative models to identify convertibles and bonds that have an attractive reward to risk. The price of the fund dropped 47% in 2008 and rebounded 56% in 2009. The fund utilizes 36% leverage and has an expense ratio of 2%. The distribution is 6% consisting of income and capital gains, with no return of capital.
- Advent Claymore Convertible Securities and Income (AGC). This CEF sells for a discount of 10.6%, which is close to its average discount of 11%. The fund has 309 holdings with 64% in convertible securities, 23% in high yield bonds, and 5% in equities. About 27% of the securities are from firms domiciled outside of the United States. Like its sister fund AVK, AGC uses quantitative models to select securities, but AGC is only 71% correlated with AVK. The price of the fund dropped 56% in 2008 and gained 58% in 2009. The fund uses a high 39% leverage and has a high expense ratio of 3.1%. The distribution is 7.3%, consisting income, capital gains, and non-destructive return of capital.
To compare the performance of the convertibles CEF to the general stock market, I also included the following ETF in the analysis.
- SPDR S&P 500 (SPY). This ETF is a proxy for the overall stock market and contains all 500 stocks in the S&P 500. It has and expense ratio of only 0.09% and yields 1.8%.
To begin the analysis, I assessed performance over an entire market cycle from 12 October, 2007 to the present. I utilized the Smartfolio 3 program (www.smartfolio.com) to plot the rate of return in excess of the risk free rate (called Excess Mu on the charts) versus the volatility of each stock. The results are shown in Figure 1.
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Figure 1: Reward and risk over bear-bull cycle
The figure indicates that there has been a wide range of returns and volatilities associated with convertibles CEFs. For example, NCV had the highest return but also had the highest volatility. Was the increased return worth the increased volatility? To answer this question, I calculated the Sharpe Ratio for each fund.
The Sharpe Ratio is a metric, developed by Nobel laureate William Sharpe, that measures risk-adjusted performance. It is calculated as the ratio of the excess return over the volatility. This reward-to-risk ratio (assuming that risk is measured by volatility) is a good way to compare peers to assess if higher returns are due to superior investment performance or from taking additional risk. On the figure, I also plotted a red line that represents the Sharpe Ratio of SPY. If an asset is above the line, it has a higher Sharpe Ratio than the S&P 500, which means it has a higher risk-adjusted return. Conversely, if an asset is below the line, the reward-to-risk is worse than the S&P 500.
Some interesting observations are apparent from the plot. First off, all the volatilities associated with the convertibles CEFs were greater than the volatility of the S&P 500. This was somewhat surprising, since convertible are usually touted to decrease volatility. The reason for the increased volatility is likely due to the employment of leverage by the CEFs and the fact that CEFs can sell at either a premium of a discount. In addition, all of the convertible CEFs experienced extremely high volatility in 2008 and 2009. However, with the exception of the Advent Claymore CEFs, the investor was adequately compensated for the increased risk. In fact, all the Calamos and the AGIC CEFs had risk-adjusted returns better than SPY. NCV had the best absolute return and the best risk-adjusted return of all the CEFs analyzed. The Advent Claymore CEFs lagged over the bear-bull cycle, with AGC barely able to stay above water.
We have seen that many of the convertible CEFs had outstanding performance over the entire bear-bull cycle. Did this outperformance continue during the recent bull market? To answer this, I analyzed the past 3 year period and the results are presented in Figure 2.
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Figure 2: Reward and risk for past 3 years
The S&P 500 has been in a rip-roaring bull market during this period, and the convertibles CEFs did not keep pace. During this period, the Calamos CEFs had the best performance, with CHI leading the pack. The two Calamos CEFs also managed to book lower volatility than the S&P 500. The AGIC CEFs were very close to CHY in terms of risk-adjusted performance. The laggards continued to be AVK and AGC.
Finally I wanted to see how these funds acted over the past 12 months, when the S&P 500 exhibited extremely strong performance. The results of the 12 months analysis are shown in Figure 3. The performance of all the CEFs was contained within a small area in the risk-reward plane, and they were all relatively close to the performance of SPY. NCZ led the pack and was the only CEF to actually outperform SPY. The performance of the Advent Claymore CEFs substantially improved over the past 12 months, and they both outperformed CHY. CHI still booked excellent performance, just off the pace of SPY, and was the second best performer among the CEFs.
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Figure 3: Reward and risk for past 12 months
Bottom Line
Given the outperformance of many of these CEFs and the large income distributions, I believe this asset class is worthy of consideration in a retirement portfolio. No one knows what the future will hold, but based on the past, my favorite CEFs are CHI, NCV, and NCZ. Since NCV and NCZ are highly correlated, I would only add one of these to your portfolio. For myself, I chose NCV, because it is selling at a smaller premium than NCZ.
Over the period analyzed, many (but not all) of the convertibles CEFs delivered excellent risk-adjusted performance. The wide range in performance means that investors need to choose carefully. All the convertibles CEFs were volatile so this asset class is only suitable for risk-tolerant investors.
Disclosure: I am long CHI, NCV. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. (More...)
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