Summary
- CSQ invests mostly in equity holdings but carries a meaningful allocation to convertible and high-yield bonds.
- The market has been quite volatile, which is impacting this fund that will mostly follow around the broader market.
- The premium has also been pushed a bit higher to overinflate some of the returns beyond what the portfolio has provided.
- For those already holding CSQ, the premium hasn't pushed to a sell level yet, in my opinion.
Written by Nick Ackerman, co-produced by Stanford Chemist. This article was originally published to members of the CEF/ETF Income Laboratory on February 17th, 2023.
Calamos Strategic Total Return Fund ( CSQ ) has been a position I've held for quite a few years. The fund is a hybrid allocation primarily focused on equity positions. However, they also have weightings in convertible bonds and high-yield debt. Generally, the fund will follow along with whatever direction the broader markets will be moving in. That's helped the fund in the first part of the new year as equities rallied.
What has also helped produce some stronger relative results for the fund was the premium extended a bit higher than when we last touched on the fund. This helps provide more returns above what the actual underlying portfolio is producing.
CSQ performance Since Prior Update (Seeking Alpha)
A premium isn't anything new to this fund in the last five years, but there have been opportunities to pick this name up at a discount for those that are patient. For this reason, the fund remains a hold, but with a new annual report and updated information on holdings available, we can provide an update for the fund.
The Basics
- 1-Year Z-score: 1.51
- Premium: 3.28%
- Distribution Yield: 8.50%
- Expense Ratio: 1.53%
- Leverage: 33.28%
- Managed Assets: $3.377 billion
- Structure: Perpetual
CSQ's objective is to seek "total return through a combination of capital appreciation and current income." They attempt to achieve this simply by; "investing in a diversified portfolio of equities, convertible securities and high yield corporate bonds."
The fund has the ability to invest where they think the best opportunities might be. That is part of the appeal of active management, the flexibility to adapt to different situations. Though it should be noted that the fund will have "at least 50% in equity securities."
This fund utilizes leverage, and that comes with the added risks of amplifying both the downside and upside moves of the fund. Additionally, the cost of floating rate leverage is rising with interest rates rising. They carry some mandatory redeemable preferred shares, but most borrowings are through a credit facility.
At the end of their last fiscal year ending October 31st, 2022 , they were paying 3.86% on the $800.5 million outstanding. Additionally noteworthy is that this was roughly $80 million less than the prior fiscal year.
The $323.5 million in outstanding preferreds are paying a fixed-rate dividend. Each of the four outstanding Series pays a different rate currently. However, they represent leverage that isn't subject to rising rates. Year-over-year, they increased this when redeeming Series A, which had an aggregate liquidation preference of $80.5 million, with Series F, which raised $100 million.
When including the leverage expenses, the fund's total expense ratio went to 2.5% from 2.03% in the prior year. With interest rates rising since then and expected to continue to rise, this would also be expected to increase.
Performance - Persistent Premium
As mentioned, the fund's premium isn't anything new. They've been flirting back and forth with this level since 2018. Prior to this, the fund had traded at a fairly consistent discount of between 5% and 10%. In 2022, we saw the fund go near a 5% discount. So we know that patient investors are likely to be able to see these buying levels again.
Ycharts
That being said, the overall market being down through 2022 still meant the shares could have been picked up at a fairly attractive deal, even trading near parity with its NAV. This would come from the fact that the fund is at the mercy of the broader market for the most part. As the market moves, so will the equity positions in its portfolio and convertible bonds. Convertible bonds being reliant on appreciation, are mostly less interest rate sensitive.
They mentioned that the weighted average duration of their bond holdings came to jus t 2.8 years at the end of 2022 . The duration is also impacted by CSQ carrying some floating rate exposure in its portfolio.
Convertible bonds have both equity and fixed-income characteristics . That would generally reduce the interest rate sensitivity. When rates were low, we saw plenty of 0% or very low coupon bonds issued, which contributed to an even higher correlation with equity prices and less dependence on the bond side. However, the interest rate sensitivity of the growth-type stocks of the underlying holdings is another matter. Since growth was impacted significantly by higher interest rates, it could be said that maybe convertible bonds are more interest rate sensitive than originally thought.
The slowing of the pace of interest rate increases could bode well for CSQ going forward. While more recent news has shown that PPI came in hotter than expected, and there is even talk of 50 basis point hikes, I still suspect we are nearer to the end of interest rate hikes than the beginning. That could help stabilize the market.
We already saw signs of that in the early part of 2023. When yields started to decline, we saw a significant rally. With the 10-Year Treasury creeping closer to the 4% level again, we are seeing a bumpier ride, but it still showed us a preview of what could happen with equities when yields moderate.
All that being said, the historical results of CSQ have been fairly strong. Perhaps unsurprisingly, given the bull market and leverage that the fund employs. Here are the annualized returns through the end of January 2023 .
In the annual report, they provide a breakdown of results relative to several blended benchmarks that can provide some more color. However, these results are only through the end of October 2022. At that point, we can see that the results are weaker due to being near the lows of the bear market.
Distribution - Caution Continues
CSQ only cut during the GFC. They've raised since and, with the last raise in 2021, achieved the equilibrium with the high water mark set back in 2008.
However, I continue to remain cautious about saying the distribution is in the clear. Things have recovered since our last update on the fund, but the NAV rate remains at 8.78%. That's the amount that the fund has to earn to cover the current distribution. If we are heading back lower due to a renewed fear of higher interest rates, we could see that spike to a higher level.
The longer it remains elevated, the greater the chance an adjustment will be needed. As is the case with most equity funds, capital gains are required to maintain the current distribution. Net investment income declined in the last fiscal year.
However, this was primarily due to amortization on the convertible bond side of their portfolio. Amortization is subtracted from the total investment income.
Adding that back would provide us with an NII of $15,936,443. Amortization can also be found in last year's report at around $7.466 million, which would mean NII would be adjusted higher last year too. The reason for the reduction in NII goes back to the leverage interest expenses climbing. Leverage costs were around $15.509 million last year. Fiscal 2022's leverage expenses came to $24.59 million.
NII coverage comes in at only around 8.2% when adjusted for amortization. This isn't unusual for this type of fund, but it helps drive home the point that capital gains are required over periods of time to cover the distribution. One or two years might not spell disaster for the distribution, but the longer a stagnant or bear market goes, the higher the chance of an adjustment.
The tax character of CSQ's distributions is mostly reflected in the fund's earnings. The largest component is identified as long-term capital gains. A large portion of the ordinary income has also been classified as qualified dividends, which further means tax-advantaged relative to ordinary income rates.
CSQ's Portfolio
Portfolio turnover for this fund isn't generally too elevated. Last year it came to 24%, and the year prior, it was 27%. With that, we also don't see dramatic shifts in the fund's asset allocation very often either. When we last looked at the fund, equity was 60.56% of the fund.
CSQ Asset Allocation (Calamos)
For convertible exposure, the latest portfolio includes 16.95% for convertibles and 11.90% for corporate bonds. The majority of their bond exposure is allocated to below-investment grade or unrated securities. The higher allocation to unrated bonds isn't new or uncommon for convertible bond funds. Saving time and costs by skipping registration and selling to qualified institutional buyers is a common practice.
CSQ Credit Quality (Calamos)
This does put us more at the mercy of the management team making the right call. They will be the ones that have to identify if the risk is worth the reward and do the due diligence.
CSQ isn't limited to any geographic area in particular. However, they remain invested primarily in the U.S. That represents 92.8% of their assets, with Europe coming in at 5.7%.
In terms of sector weightings, CSQ is heavily weighted toward tech investments. It carries a smaller allocation to tech relative to the S&P 500 Index. Over the last year, it has come down some, but last stood at around 27.45% of the index. On the other hand, compared to the other sector allocations, it still represents a hefty portion of the portfolio for the fund.
CSQ Sector Weightings (Calamos)
Helping to bolster those sorts of weightings is represented by the fund's overweight allocation to mega-cap tech stocks that they've continued to maintain.
The top ten represent 20.2% of the overall fund. The usuals, Apple ( AAPL ), Microsoft ( MSFT ), Amazon ( AMZN ) and Alphabet ( GOOGL ) make up a disproportion of 12.8%.
AAPL and MSFT, in particular, are overweight positions relative to the other weightings in the fund. They've held up relatively well compared to the other two, which helped limit some of CSQ's own downside in 2022.
Ycharts
These were similar weights to what we saw a year ago . So we haven't seen too significant of a shift in the fund overall. Similar to the S&P 500, tech's allocation had come down from a year ago.
Conclusion
Overall, this fund is mostly at the mercy of the broader market despite being a hybrid fund. The reason is that they are overweight common equity positions with a sizeable allocation to convertible bonds. They carry some corporate bonds, but with an emphasis on below-investment grade means a higher correlation to equities too.
CSQ remains at a premium, but not to a level that would make me want to sell yet. More patient investors should wait for a discount before scooping shares up.
For further details see:
CSQ: Premium Persists, Keeping This A Hold For Now