Convertibles are on the agenda. They played a leading role in financing the US railroad boom of the start of the 20th century, and in Japan in the 1980s when the countr y’s issuance represented 40% of the global convertible market.
Bank recapitalisation will involve them. Goldman Sach’s agreement with Warren Buffett’s Berkshire Hathaway to sell $5bn (€3.9bn) of preferred stock in conjunction with warrant to buy $5bn in common stock at an agreed price also represents a convertible issuance. “I’d like to be in Warren Buffett’s shoes with 10% yield and upside too,” comments John Calamos, (pictured right) co-CIO of Calamos Investments, and a 38-year convertibles veteran.
“He’s going to double his money in seven or 10 years just in the interest income, and if the stock goes up he makes some there too. So he gets paid to wait. And if they use the capital correctly, as he hopes they will, he gets the upside, which is different to being a straight debt holder.”
Calamos Investments, based in Naperville, Illinois, is hoping that institutional investors - including European ones - will follow Buffett’s example. There are historic opportunities in convertibles at the moment, and ones that could reward their long-term horizon.
In contrast, the unravelling of performance in the convertible arbitrage hedge fund arena is startling. According to Edhec hedge fund strategy performance statistics in this issue (see page 63), convertible arbitrage returned -12.98% in October alone, -26.25% in the year to end-October and an eye watering -55.06% in the three months to end-October.
“The problem we all have at the moment is the lack of transparency in the hedge fund community and that is something that government regulation has to address,” says Calamos. “We are all for free markets but free markets mean a fair playing field for everyone. The best free markets are the ones with transparency.”
And of course, Calamos’ strategies have been affected too by this downturn: the Calamos Global Opportunities fund, which invests in a combination of stocks, bonds and convertibles, returned -23.16% in 2008 to end-September, expressed in dollar terms.
Calamos points out that while convertibles in themselves are a conservative strategy, leverage has been the undoing of many a hedge fund in the convertible arbitrage area. “It’s pretty bloody because they use a high degree of leverage. They take a strategy like convertible arbitrage, which is very conservative on a cash-only basis, but if you leverage it up seven or eight times to one, it gets risky all of a sudden.” So the forced selling of the convertible arbitrage community has contributed to what Calamos and his colleagues think is a very attractive opportunity in convertible bonds.
Calamos Investments estimates that convertible securities overall are undervalued by as much as 10-11% using its fair price models. “I think what we are seeing is that there are many dislocations in the market today in various asset classes and obviously convertibles are one of those that we feel have declined much worse than you thought they would have, considering their attributes,” says Calamos.
In ‘normal’ market downturns, investors would expect convertibles to hold up well, given the fact that they contain an embedded option on the firm’s equity. That was the case in previous downturns, but not this one.
“I have been investing in convertibles since 1970 and have gone through many periods which were similar to this. But in a recession convertibles have provided a cushion from their fixed income characteristics. This is the first time that I have seen convertibles not provide that on the downside. Part of that, of course, is due to the deleveraging of the hedge fund community in convertible arbitrage.”
For pension funds at the moment, the dilemma is where to invest incoming cash given that the equity market crash will have skewed their asset allocation away from target ranges, and equities will be considerably underweighted in many cases. But do they rebalance back towards equities using the same managers, do they park assets in cash or do they find some other strategy?
Calamos suggests that those needing to rebalance should consider convertibles because of their defensive qualities in times of economic strain and their upside potential.
“We suggest that convertibles, over the years, are a defensive equity strategy if you manage towards that investment objective. So we think that using a convertible strategy as a defensive equity strategy makes sense in what we think will continue to be a volatile market,” Calamos says.
“But the types of convertibles that you use to achieve that are different than with a convertible arbitrage strategy,” he continues. “However, we see opportunities in both those areas, and one of them is to take advantage of the current dislocation in the market and hedge some of those opportunities.”
So Calamos is also increasing allocations to convertibles across its strategies. “We also have the Global Opportunities strategies on the UCITS platform that combine convertibles with equity and what we are doing there is including more convertibles because they are so cheap.” In the US, it has also re-opened its Convertible strategy. Launched in 1979, it had been closed to new investors since April 2003.
But over what time period will a defensive convertibles strategy work? “First, if convertibles reverted to normal valuations this would not make them a bad strategy. If the credit markets came back to something close to normal, you would have convertibles come closer to their fair value. So even if the stocks did not move in that environment you may see a ‘pop’ in valuations in the convertible side. That is a short-term benefit.”
Part of the assumption, he continues, is that Calamos Investments believes that credit markets won’t thaw in the short term. “The current environment is a credit freeze: If you have no credit or banking system anywhere in the world, guess what? The economy doesn’t work very well. But as it thaws - which it looks like it’s beginning to do because of government action and everything else - we’ll still have volatility and convertibles are a good opportunity.”
Short-term market timing is difficult, concedes Calamos. “You have to look at valuations and they have to be consistent with your long-term view. And as government programmes begin to work, markets will return to normal volatility.”
Calamos also stresses that it’s not the convertible itself that makes the strategy, it’s how you use it. “Convertibles are unique securities - they are complex, they have fixed income characteristics and optionality, as well as equity characteristics. Each security has its own risk-reward.”
Calamos Investments is also to launch a hedge fund strategy. This is not that much of a counterintuitive business plan - in fact it will use some hedging techniques without being market neutral or leveraged. “In other words, it is a very selective bottom-up strategy. If we see an undervaluation can we lock that up? But essentially it is a long-only strategy, with the ability to hedge macro risk, to hedge individual securities and with the use of some options. It’s a more flexible strategy but it is a long-only investment strategy and not a market-neutral objective.
What of the capacity issue, which drove Calamos Investments to close its flagship US fund five years ago? “This is a limited capacity market. It’s still that way and there have been no new issues yet this quarter, but if we look out a bit further, debt spreads are very wide, as the economy gets to a little a bit more normal, companies will seek financing and convertibles provide a good alternative to seeking financing because companies will be willing to give up some of the upside in equity for a lower cost of debt.”
But Calamos is hopeful that there will be greater capacity in the market. He notes that convertible issuance spikes at times of high debt spreads, at the expense of conventional corporate debt. “What we have had in the last three-four years is straight debt issuance at record levels and convertible issuance at meagre levels. We think that this will flip-flop going forward.
“There are issues in the emerging markets and we think the global convertible market will do well,” Calamos concludes. “Even in a slow growth environment there are companies that have the opportunity to grow and need finance to grow and convertibles are the lowest cost capital. It’s lower than the cost of debt and lower than equity.”
John Calamos is chairman/CEO/co-CIO, Calamos Investments. After a stint as a combat pilot in the Vietnam War, he devoted his entire career to investment management. He founded Calamos Investments in 1977.
Calamos is a member of the Investment Analysts Society of Chicago. He has also published two books - ‘Investing in Convertible Securities: Your Complete Guide to the Risks and Rewards’, and ‘Convertible Securities: the Latest Instruments, Portfolio Strategies, and Valuation Analysis’, along with numerous articles in various financial journals.
He received his undergraduate degree in economics and MBA in finance from the Illinois Institute of Technology.