CCD - CCD: Good Way To Generate Income If You Are Bullish On Growth Stocks

2023-08-09 07:38:58 ET

Summary

• Calamos Dynamic Convertible and Income Fund is a high-yielding closed-end fund that invests in convertible corporate bonds from various industries.
• Convertible bonds come with specific risks as they participate in stock rallies and market crashes, and rely on bond yields and capital gains to pay dividends.
• Keep in mind that most companies that issue convertible bonds don't have the highest credit rating.
• This fund works best during bull markets when growth stocks are rallying, so I would recommend buying if you are bullish on growth stocks right now.

Calamos Dynamic Convertible and Income Fund ( CCD ) is a high-yielding closed-end fund that mostly invests in convertible corporate bonds from a large variety of industries. The fund was created in 2015 and it has a 4-star Morningstar rating. I believe this fund could be a decent addition to investors' income portfolio, but it comes with certain risks, which I will describe below.

Since its inception, the fund saw its share price drop somewhat and its total return came at 45%. By January 2022, the fund's total return was as high as 86%, but it dropped significantly since then due to a drop in both stock and bond prices.

When you invest in convertible bonds, you are basically investing in a mixture of stocks and bonds. You are buying bonds, but since those bonds are convertible to stock above a specific price point, the bond actually trades very close to how the underlying stock trades. When the underlying stock rallies hard, so does the convertible bond, and when the underlying stock drops significantly, the same happens to the convertible bond as well. As a result of this, convertible bonds and convertible bond funds come with a specific risk. On one side, they participate in stock rallies to an extent, and on the other hand, they also participate in market crashes and bear markets to an extent.

Since convertible bonds come with much lower interest rates than regular bonds, convertible bond funds rely on both on bond yields as well as capital gains in order to pay their dividends. CCD has a current dividend yield of 10.33% which is only sustainable if the stock market continues rallying.

Corporations issue convertible bonds because it allows them to take debt at much lower interest rates, but this also means that if the bonds are converted into shares, it can result in pretty sizeable dilution for existing shareholders, so it's not exactly free money either. CCD holds more than 550 convertible corporate bonds, which gives you plenty of diversification that you wouldn't be able to create by yourself unless you have very large funds (especially considering many convertible bonds have minimum investment amounts that must be met).

When we look at the fund's top 10 holdings, we see several familiar names such as ON Semiconductor ( ON ), Uber ( UBER ), Ford ( F ), Palo Alto Networks ( PANW ), and Vail Resorts ( MTN ).

Let us take a look at a few of those holdings. The fund holds ON Semiconductor's convertible bond expiring in 2029 which had a coupon of only 0.5%. This bond would generate very little yield, and the fund needs to see price appreciation in order to make money on it. CCD doesn't specify what the convert strike price of these bonds is, but considering that ON has rallied about 63% year to date, it's safe to say that these convertible bonds also appreciated significantly in price.

Next, I am seeing convertible Uber bonds expiring in 2025 in CCD's portfolio. Interestingly enough, this is a no-coupon bond, meaning it doesn't pay an interest. Considering that Uber's traditional 2025 bonds yield about 7.5%, the company is saving a great deal of money by selling zero coupon convertible bonds. CCD can only profit from this trade if Uber's share price rallies. At this point, you might think that why the fund isn't just buying Uber shares instead of this bond. Well, if it buys Uber shares and Uber's share price drops significantly, it can lose a lot of money, but if it holds bonds until maturity they can at least get their principal money back. Luckily for CCD, the stock is up 81% year-to-date, so it enjoys a good deal of appreciation on those zero coupons.

Many people think convertible bonds are like options, but they are not. If an option's strike price is not hit by its expiration, the option expires worthless. If a convertible bond's convert price isn't hit at maturity, bondholders still get their original investment back (unless the company went bankrupt and has no way of paying any of its debts back, which is very rare).

Generally speaking, the fund is overweight in certain industries such as technology, but this is no surprise considering that tech companies are more likely to issue convertible bonds because of two reasons. First, many tech companies are start-ups in nature, and they would have to pay a high interest rate for their regular bonds. Second, tech stocks tend to rally stronger during bull markets, which gives them more room to be able to sell convertibles to institutions. It would have been harder for a stock like Coca-Cola ( KO ) to sell convertibles because its share price barely moves, so institutions have less incentive to buy those convertible bonds.

Convertible bonds tend to have much lower bond durations because of their nature, so it is no surprise that the average bond held by CCD has a maturity of 3.4 years. Issuing convertibles with longer durations would pose a risk for both parties. For the issuing company, it would mean that it might have to worry about a possible dilution for many years instead of just a few, and for participating institutions, it might mean holding a volatile asset for much longer than needed. Typically, most convertibles will mature within 3-7 years and companies will roll their debt out with new bonds if needed. Many companies also consider convertible bonds as a temporary solution until they can get their credit rating higher and qualify for lower yields.

This brings us to the next topic, which is credit ratings. As of July 31st of this year, none of CCD's holdings are rated AAA or AA and only 1.9% of the fund's holdings have an A rating. All in all, 73.2% of the fund's assets are in securities without a credit rating. This also makes sense since AAA-rated companies don't need to issue convertible bonds because they can already command super low yields with traditional methods. Many of these companies who issue convertible bonds are trying to build up their credit rating. Think of it like a college student who doesn't have a credit rating, so he gets a secured credit card in order to build a credit history and credit score. This is what many of these companies are doing.

As long as the bull market continues and stock prices climb, funds like CCD should be able to cover their dividends. This year, almost all of the fund's dividend distributions came from long-term capital gains, which is good from both sustainability and tax perspective. If we were to get a prolonged bear market, the fund might have to resort to return of capital in order to sustain its dividends, though.

Basically, it all comes down to one thing. If you are bullish on stocks (especially growth stocks), you might want to buy this fund to supplement your income. If you are bearish on stocks and want to gain exposure to bonds for safety purposes, you might be better off buying government bonds or corporate bond funds that mainly deal with AAA-rated bonds.

In the long run, I am almost always bullish on growth stocks, but given the rich valuation they enjoy today, I am more inclined to rate this fund "hold" at the moment.

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