2023-07-12 12:22:42 ET
Summary
- The Calamos Strategic Total Return Fund provides exposure to a flexible portfolio with an emphasis on equity positions and meaningful exposure to convertible and high-yield bonds.
- The fund's performance has been strong, delivering superior results against its blended benchmark. However, with rising leverage costs, future outperformance could be more challenging.
- Despite these challenges, the fund remains a solid hold for long-term investors. An alternative would be suggesting a more cautious approach by dollar-cost averaging in.
Written by Nick Ackerman, co-produced by Stanford Chemist. This article was originally published to members of the CEF/ETF Income Laboratory on June 28th, 2023.
Calamos Strategic Total Return Fund ( CSQ ) provides exposure to a flexible portfolio for investors. The fund is actively managed with an emphasis on equity positions, but they also include meaningful exposure to convertible and high-yield bonds. The fund has beaten its benchmarks over the long and short term. The fund also provides an attractive distribution yield to investors paid monthly.
However, with the latest semi-annual report , we see that net investment income has slipped. In fact, the fund now has no NII to provide coverage for the fund's distribution as interest rates have risen substantially to drive up borrowing costs. The way the fund is positioned, it always required a substantial amount of capital gains to fund its distribution in the past. So overall, it isn't a big change, but it is something to be aware of. Also worth considering is that if the NII was adjusted for amortization, they would have shown some positive NII.
Additionally, the fund had shifted to a small discount from our last update when it was at a slight premium. Premium pricing in the last five years or so isn't that unusual. It still makes it a fairly solid hold for long-term investors, but if one is entering today, they could utilize a dollar-cost averaging approach. I feel being a bit more cautious about adding aggressively makes sense because, before the last five years, a discount had been usual for this fund.
The Basics
- 1-Year Z-score: -1.08
- Discount: -1.51%
- Distribution Yield: 8.55%
- Expense Ratio: 1.59%
- Leverage: 33.46%
- Managed Assets: $3.359 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."
The fund's expense ratio is fairly high, but it isn't all that unusual for a multi-asset approach that is employed. When including leverage expenses, the fund's total expense ratio comes to 3.82%. This was quite the leap from last fiscal year's 2.5% listed. The substantial jump came from higher borrowing costs as the Fed has ramped up interest rates. This is something most leveraged closed-end funds are grappling with.
CSQ hasn't felt the full brunt of higher interest rates just yet, though. This is because some of the $800.5 million the fund has in leverage is through fixed-rate mandatory redeemable preferred shares.
These costs could potentially increase if they had their ratings downgraded from the AA- level currently.
Performance - Strong Track Record
While leverage costs are rising, portfolio selection and leverage in the last bull market have seemingly driven strong long-term results for the fund. Against the fund's blended benchmark, they've delivered superior results. The benchmark is a blend of the S&P 500 and a convertible and high-yield index. This performance is even despite the higher expense ratio seen in the CEF structure. Note that these results are from the last semi-annual report, which is the six months ended April 30th, 2023.
Going forward, with higher leverage costs, the outperformance could be considerably more challenging. Conversely, when interest rates drop, that could act as a bit of a boost for the fund as leverage costs would start to decline.
Another area of the fund that will make performance a bit more challenging on the market price is that the fund had historically traded at a discount. The last five or so years of the fund flirting with a premium have been more of an unusual experience.
Generally, buying a fund at a large discount or closer to its historical average is a more ideal situation. Going forward, if an investor were to buy at today's valuation and the fund returns back to a ~7% discount, an investor would be looking at losses. This could be because even if the underlying portfolio performs fairly well, it could put an investor at a disadvantage and could result in otherwise poorer results.
This is ultimately why I believe that it would be more appropriate to hold or use a dollar-cost averaging approach to enter a position in the fund rather than going all in. Valuations can play a significant role in future results, and even if the fund has returned to a shallow discount, it's still historically on the more expensive side.
Distribution - Attractive Rate
For investors who are holding the fund, we have an attractive distribution that we've been receiving monthly. The latest monthly distribution amount matches the pre-GFC of 2008/09 levels. That's pretty impressive for a CEF as they typically pay out the majority of all their earnings and, after crashes, don't return to their peak payouts or peak prices.
The NAV price today is right around where it was at inception. Which is pretty much exactly what we want for a CEF, it means they've paid out their distributions over the years, and it's been covered through gains and income. At this point, they've now paid out just under $19 in total distributions.
As noted above, higher leverage costs have driven NII to a negative figure. However, with NII coverage in the prior year at around 4%, it isn't as though this fund is drowning in interest and dividends.
This isn't that unusual for equity funds, either. The other factor at play here is amortization has taken out a fairly meaningful amount of total investment income. Factoring that out would drive NII positive, but again, only barely so and isn't a substantial point for providing coverage to the fund. That being said, this was also a factor in the previous report as well.
Some of the higher leverage costs have been offset as well through higher interest collection in the fund. If we look at the above TII, that would annualize out to around $42.483 million - above the $34.25 million for the entirety of fiscal 2022 . If this pace continues and interest rate increases remain mild as expected, we could see NII improve going forward.
One of the reasons this could be occurring is due to higher yields coming from convertibles and high-yield bonds. Now that rates have risen, new issues have to come with higher yields to be competitive and get investors. Convertibles, in particular, are actually starting to see yields pick up, as noted by Calamos themselves.
In fact, the quality of issuers is also picking up, as they noted. Most convertibles are unrated as they are private placements for qualified institutional buyers, but Calamos noted higher quality issuers as a way to reduce the rising costs of borrowings for companies themselves. Instead of investment-grade companies issuing debt at higher rates for straight debt, they can get away with issuing convertibles at lower yields as they can also provide potential upside for capital gains for investors.
Calamos has seemingly been comfortable paying higher rates on some of their funds. CSQ is at a NAV rate of 8.42%, so I don't see them being compelled to cut the current distribution anytime soon. Of course, that's assuming no black swan events for the foreseeable future, which always changes every situation.
CSQ's Portfolio
Average portfolio turnover comes to 18.7%, meaning they aren't necessarily the most aggressive out there in terms of making changes in their underlying portfolio. They've also pretty much consistently stuck with their asset weightings at a fairly predictable level. In our prior update that showed for the period ended January 31, 2023, they had equity positions at 61.09% of their portfolio. Prior to that, the weighting was 60.56%.
This is also consistent with the fund's "...at least 50% in equities..." approach. The latest convertible pie came to 17.64%, with high-yield corporate exposure at 11.67%. With the fixed-income side of their portfolio, the majority is listed as unrated due to the convertible exposure being a larger portion of the sleeve. However, they also carry some investment-grade quality, too, at around 24.5%.
This was an increase from 19.8% and could be reflecting some of what Calamos had noted about being able to get some decent coupons with higher quality issuers. This will be one area that is worth monitoring as we move forward in this higher-rate environment.
Overall, their bond duration comes to 2.7 years, which makes them fairly low in terms of interest rate sensitivity.
Looking at the portfolio sector weights, we see the fund continues to favor tech.
That isn't that unusual. Tech has been most of the growth driver in terms of portfolio returns, so naturally, even if they didn't do anything, tech weightings would increase. This is a more growth-oriented fund rather than looking at income players. Not that they don't hold plenty of companies that issue dividends, but the companies are primarily looking for growth. That becomes quite apparent when looking at the fund's top ten.
Eight of the top ten could be classified as tech/growth companies with heavy representation in the portfolio provided thanks to Apple ( AAPL ) and Microsoft ( MSFT ) taking up a significant 11.4% of the fund's assets.
All top ten names are equity positions and don't represent any of the fixed-income sleeves of the portfolio. This is mostly consistent with what we often see with this fund. Previously, they had listed the iShares China Large-Cap ETF ( FXI ) as the tenth largest position. That ETF no longer appears on the complete holdings list , though that list is available as of April 28th, 2023.
Conclusion
CSQ remains a solid fund worth holding, but even with a current discount, it isn't necessarily presenting a strong time to consider entering the fund. Ideally, a discount closer to 10% could represent a strong time to consider the fund. That would put it below its longer-term average, which is being skewed by more recent years anyway.
Considering the higher interest rate environment, a larger discount could be appropriate as well. With higher interest rates come higher borrowing costs, reducing or eliminating the upside potential that can come with leverage - while simultaneously still exposing to all the downside of leverage as well. Thus, for these reasons, continuing to hold the fund could be appropriate or adding only potentially smaller slices with a dollar-cost averaging approach.
For further details see:
CSQ: Strong Track Record With An ~8.5% Distribution Yield