CCD: Great Opportunities From Convertibles On This High Yielder

Summary

• Convertible securities offer the best of fixed-income and common stocks.
• CCD is one of the easiest ways for investors to purchase these securities and obtain a 7.57% yield at the same time.
• The policies of the Federal Reserve have made it exceptionally difficult for investors to obtain any level of income.
• The distribution of the fund appears to be quite safe.
• The fund is currently trading at a greater premium than normal so it looks rather expensive.
• Looking for a helping hand in the market? Members of Energy Profits in Dividends get exclusive ideas and guidance to navigate any climate. Learn More »

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One of the more interesting types of security is convertibles. These are fixed-income securities that are capable of being converted into common equity of the issuing company once certain conditions are met. This helps to solve one of the biggest problems that many investors have with fixed-income securities. Basically, that problem is that fixed-income investors do not share in the upside potential that common equities possess and some of these stocks are of companies that have seen a very strong run-up over the past few years like Tesla (TSLA).

In effect then, they offer the high yield of fixed-income securities and the upside potential of the common equities. The trade-off is that they do not offer as high of a yield as other fixed-income securities offered by the same company. It can be difficult for ordinary investors to purchase shares of these securities though, especially retail investors. One solution to this is to invest in shares of a closed-end fund that invests in these securities. In this article, we will look at one of these funds, the Calamos Dynamic Convertible and Income Fund (NASDAQ:CCD), which currently yields 7.57%. Let us attempt to see if this fund could be right for your portfolio.

About The Fund

According to the fund’s web page, the Calamos Dynamic Convertible and Income Fund has the stated objective of generating a high level of total return, primarily through capital appreciation and income. This is not unique as most fixed-income closed-end funds have a similar objective. The thing that makes this one unique is that it aims to achieve this objective by investing in fixed-income convertible securities. The fund has a second strategy as well and that is to sell call options.

This is a strategy that many closed-end funds use to generate income as it works very well. The basic goal with this is to pocket the call premium and hope that the option expires worthless. The fund has not stated on the web page exactly how it implements the options strategy though but presumably these are covered calls as most other options strategies are considered too risky for a closed-end fund.

Convertible securities are often issued by start-ups or other unprofitable companies that would otherwise have a very difficult time raising money in the traditional debt markets. This is due to the fact that the convertible option allows the company to pay a lower interest rate than it otherwise would. We can in fact see this by looking at the largest positions in the fund:

Source: CEF Connect

We can see here companies like Uber (UBER) and Tesla. Tesla in particular has been a very high-flying stock in the market over the past several years. The presence of this security in the portfolio thus may be appealing to many investors as it essentially provides exposure to the upside of the common stock through the convertible feature while still providing income to the fund that ultimately flows through to investors. We also see a few companies here that were severely impacted by the pandemic like Royal Caribbean Group (RCL).

The presence of this security thus adds a bit of a recovery play to the fund since it appears likely that this stock will appreciate as the pandemic subsides and people become more willing to embark on cruises and return to their pre-pandemic lives. In the meantime, the fund receives income while we wait for this story to fully play out.

Although the name of the fund implies that it is exclusively a convertible fund, this is not the case. Officially, the fund only has to invest at least 50% of its assets into convertible securities but it is currently quite a bit higher than that:

Source: CEF Connect

As we can see here, approximately 18.91% of the portfolio is invested into more traditional fixed-income securities like bonds and preferred stocks. These do not have the same upside potential as the convertible securities but their presence could still be a good thing due to their higher yields and greater amounts of stability. This could help make the fund less volatile, which could be appealing to those investors that desire a certain degree of principal protection. In the meantime, the relatively high exposure to convertible securities provides the fund’s investors with exposure to the upside potential of these securities.

One thing that we notice from looking at the largest positions in the fund makes one think that the fund has a great deal of diversity across sectors. This is indeed the case:

Source: Calamos Investments

This is nice because all of these sectors have very different fundamentals. This is something that gained a great deal of importance over the past year as the pandemic had very different impacts on each sector. For example, hospitality was far more adversely impacted by the lockdowns than technology or healthcare. As a result, a portfolio with heavy exposure to a given sector that was very negatively impacted by the lockdowns would have delivered worse performance than a technology- or healthcare-heavy portfolio. Thus the fund’s diversity across sectors should reduce volatility in the event of economic shocks like the one that we saw last year.

As mentioned earlier, convertible securities are frequently issued by companies that would otherwise have difficulty raising capital at affordable rates. As such, we might expect that the ratings on these securities are not particularly high. This is indeed the case:

Source: Calamos Investments

As a general rule, anything rated BBB or above is considered investment-grade and thus at low risk of default. As we can clearly see, that is only about 9.1% of the portfolio. Anything below that is considered to be at fairly high risk of default. This may concern many investors, particularly those concerned with preservation of capital. This should not be as worrying as it might at first appear though. As we have already seen, the fund has a great deal of diversity across sectors and between individual companies.

Thus, if only one company defaults on its convertible securities, the impact on the fund as a whole should be negligible. Only something like mass defaults across the whole economy could have a significant impact on the fund and if that happens, pretty much everything in the market will fall significantly.

The Need For Income

The primary attraction of convertible securities is the fact that they provide investors with a source of income while offering the upside potential of common stocks. Thus, they can help investors to solve one of the biggest problems facing them today. That problem is the inability to generate any significant degree of income off of their portfolios. This problem is caused by the policies of the Federal Reserve, specifically its control of the federal funds rate.

This is the rate at which the nation’s commercial banks lend money to each other on an overnight basis. As we can see here, the bank cut this rate to all-time lows in an attempt to stabilize the economy following the collapse of Lehman Brothers in 2007. The bank kept the rate at this low level until it finally attempted to raise it during the Trump Administration but even then the rate remained at historically low levels. The pandemic changed this and the bank was again forced to cut the federal funds rate to all-time lows, where it remains today:

Source: Federal Reserve Bank of St. Louis

As of the time of writing, the federal funds rate stands at 0.08%. This is important because the federal funds rate influences the interest rate of everything else in the economy. This is the reason why things like bank savings accounts and certificates of deposit are paying essentially nothing. This has rendered traditional retirement strategies like laddering certificates of deposit essentially useless.

This inability to derive income from traditional methods has forced investors to put their money into riskier assets like stocks and bonds. This has had the unfortunate effect of pushing prices up and yields down. We can see this quite clearly by looking at the S&P 500 index (SPY), which currently yields 1.26% as of the time of writing. At this yield, a $1 million portfolio would only generate $12,600 in annual income. This is obviously nowhere near enough to finance any sort of retirement lifestyle like someone that managed to save up a $1 million portfolio would expect.

The bond market is not really any better. This is because the interest rate on bonds is dependent on the federal funds rate. Thus, the low federal funds rate has resulted in the interest rate on newly issued bonds also being incredibly low. Investors have responded by bidding up existing bonds until they have a similar yield to that of comparable newly issued bonds. We can see this by looking at the iShares Core U.S. Bond ETF (AGG), which currently yields 1.87%. At this yield, our hypothetical $1 million portfolio would only generate $18,700 in annual income. This is likewise nowhere near enough to generate a reasonable level of retirement income.

The Calamos Dynamic Convertible and Income Fund is able to do much better than this due both to the nature of the assets that it invests in and its closed-end structure. As mentioned earlier, this fund currently yields 7.57%, which kicks the income generated by our hypothetical $1 million portfolio to $75,700 annually. When we combine this with likely Social Security benefits, we can see that the retirement income should be sufficient to enjoy a middle-class lifestyle in most areas of the country.

Distribution Analysis

As the name of the fund implies, the Calamos Dynamic Convertible and Income Fund has the purpose of providing its investors with a certain level of income. As such, we might expect it to make regular distributions to its investors. This is indeed the case as the fund pays out a monthly distribution of $0.1950 per share ($2.34 per share annually), which gives it a 7.57% yield at the current price. The fund has been quite consistent with this payout over the years, even raising it this year:

Source: CEF Connect

This consistency is something that is highly likely to be appealing to someone that is looking for a very sustainable level of income. Another thing that may be appealing is the fact that these distributions are largely classified as dividends or capital gains with no return of capital component:

Source: Fidelity Investments

The reason why this could be appealing is that a return of capital distribution can be a sign that the fund is returning the investors’ own money back to them. This is obviously not sustainable on any sort of extended basis. There are other things that can cause a distribution to be classified as return of capital though so as the distribution of unrealized capital gains. According to this though, we do not need to worry about that here. As I discussed in a previous article though, it is possible for these distributions to be misclassified. Thus, we should investigate exactly how the fund is financing this distribution in order to determine how sustainable it truly is.

Fortunately, we have a fairly recent report that we can use for this purpose. The fund’s most recent financial report is for the six-month period ended April 30, 2021 so while it does not include data for the past three months, it should still give us a very good idea of how well the fund performed recently, especially in the strong bull market earlier this year. During that six-month period, the fund collected $13,150,692 in interest and $3,602,985 in dividends off of the investments in its portfolio for a total of $16,753,677.

The fund paid its expenses out of this amount, leaving it with 9,238,468 available for the investors. This alone was not enough to cover the $26,592,127 that it actually paid out in distributions though. A fund like this has other methods to get money for the distribution though such as through capital gains. In the six-month reporting period, the fund had $72,381,461 in realized and another $100,848,268 in unrealized capital gains. This is more than enough to cover the distribution when combined with the fund’s income. Thus, we can conclude that the distribution is likely reasonably safe for the time being.

Valuation

As is always the case, it is critical that we do not overpay for any asset in our portfolios. This is because overpaying for any asset is a surefire way to ensure that we generate suboptimal returns off of that asset. In the case of a closed-end fund like the Calamos Dynamic Convertible and Income Fund, the usual way to do this is by looking at a metric known as the net asset value. The net asset value of a fund is the total current market value of all of the fund’s assets minus any outstanding debt. It is therefore the amount that the investors would receive if the fund were immediately shut down and liquidated.

Ideally, we want to purchase shares of the fund when we can get them at a price that is less than net asset value. This is because such a scenario implies that we are acquiring the fund’s assets for less than they are actually worth. That is unfortunately not the case here. As of July 29, 2021, the fund had a net asset value of $30.66 per share but currently trades for $31.04. This represents a premium of 1.24% to net asset value. This is a bit more than the 1.00% premium that the fund has had on average over the past month so the price admittedly looks high at the current level. Potential investors may want to wait until it comes down a bit before buying in.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.