2023-09-19 12:56:48 ET
Summary
- The Calamos Strategic Total Return Fund invests in a diversified portfolio of equities, convertible securities, and high-yield corporate bonds.
- The fund's market performance has been decent, but there are other funds that have outperformed it.
- The fund's bond allocation is weighted towards high-yield bonds, which have attractive yields but also higher risk.
- The fund's common stock portfolio is increasingly weighted to long-duration technology stocks, which have been run up in price and may not make sense today.
- The fund's shares currently look pricey, so it may be best to wait for a correction before buying in.
The Calamos Strategic Total Return Fund ( CSQ ) is a somewhat interesting closed-end fund, or CEF, that invests in assets all across the capital structure. The fund includes common and preferred stocks, as well as bonds, and even hybrid securities. It also has an attraction for anyone who is seeking to earn a high level of income, as its 8.27% yield is higher than most other things in the market. The fund’s market performance has not been too bad either, as the fund is up 5.68% over the past year:
This is certainly not bad compared to things like the Bloomberg U.S. Aggregate Bond Index ( AGG ), which is down 3.09% over the same time period. However, it is also not especially impressive as there have been several other funds that have outperformed this one. As I pointed out in a recent article though, it is possible for a fund’s market performance to differ significantly from the performance of the actual underlying portfolio, so this is something that we will want to pay specific attention to as we proceed through our analysis and discussion.
As regular readers may recall, we last discussed this fund back in May. At that time, everything looked good, but the fund’s portfolio was heavily allocated to the technology sector, which was going through a massive artificial intelligence bubble at that time. This bubble has started to deflate now that it is becoming more and more evident that the Federal Reserve will not be cutting interest rates anytime soon. In an environment like this, short-duration stocks, money market funds, and even short-term bonds tend to be more attractive assets. We should thus see how the fund has changed its holdings considering this new environment. In addition, the fund has released its semi-annual report since the time of our last discussion, so we should definitely review this in order to see how sustainable the distribution actually is.
About The Fund
According to the fund’s webpage , the Calamos Strategic Total Return Fund seeks to achieve a high level of total return. This is not surprising considering that the fund’s expanded objective mentions that it will use a variety of assets to accomplish its goals. From the website:
The Fund seeks total return through a combination of capital appreciation and current income by investing in a diversified portfolio of equities, convertible securities, and high-yield corporate bonds.
The fund’s portfolio confirms that it is indeed running such an asset mix. As we can see here, the fund currently has 63.92% of its portfolio invested in common stocks, with the remainder of the portfolio invested in bonds and hybrid securities:
CEF Connect
This is a fairly good asset mix and it is certainly very different from the usual 80% or higher common stock allocation that we typically see in other blended funds. With that said, though, there are some reasons to have a heavier weighting to bonds now than most of us have had over the past fifteen years.
One big reason for this is that interest rates are higher than they have been in more than twenty years. As everyone reading this is certainly well aware, the Federal Reserve has been very aggressively raising interest rates in an effort to combat the high levels of inflation that have been plaguing the economy over the past few years. This is evident in the federal funds rate. As of the time of writing, the effective federal funds rate stands at 5.33%, which is the highest level that it has had since February 2001:
There might be some people who question the wisdom of holding bonds in such an environment. After all, bond prices decline when interest rates rise, and as I have mentioned in several recent articles, there is a risk that interest rates will rise further and hurt the bonds in our portfolios. However, this is not a problem if the bonds are held to maturity. One of the defining characteristics of bonds is that an investor who buys a bond when it is first issued and holds it to maturity will not lose money on a nominal basis unless the issuer defaults. The coupon yield will thus be the return for such an investor and coupon yields are higher than they have been in more than two decades.
For example, six-month U.S. Treasuries are at 5.531% right now. Even the one-year Treasury is at 5.442%, and corporates have even higher yields. That is not really a bad return for locking up your money for six months or a year, especially when we consider how volatile the stock market has been recently. There can certainly be a real argument to hold a higher percentage of your portfolio in bonds than there would have been two years ago when rates were basically zero (and real yields were negative). The fund seems to recognize this and is holding some of its portfolio in bonds to reduce volatility. It actually makes sense to do this considering where yields are at.
This is especially true considering the fund’s statement that its bond holdings are specifically in high-yield bonds. These are colloquially known as “junk bonds” and they have a much higher yield than Treasuries, which is intended to compensate for their higher risk of default-related losses. There are two well-known indices tracking these bonds, and they have very respectable yield-to-maturity right now:
Index/ETF | Average Yield-to-Maturity |
Markit iBoxx USD Liquid High Yield Index ( HYG ) | 8.38% |
Bloomberg High Yield Very Liquid Index ( JNK ) | 8.64% |
It is very difficult to argue that assets with yields this high will drag a portfolio’s performance down. Indeed, these yields are beginning to approach the long-term total return of some of the major stock market indices. The fund’s bond allocation is weighted towards these securities, but it is not as high as might be expected. We can see this by looking at the credit ratings that have been assigned to the securities in the fund’s portfolio. Here they are:
Calamos
An investment-grade bond is anything rated BBB or above. As we can see, this accounts for 26.1% of the fund’s bond holdings. The remainder of its fixed-income allocation is in speculative-grade bonds. However, it is important to keep in mind that we do not know exactly what the quality of those unrated securities is. It is unlikely that they are comparable to investment-grade bonds. After all, any company with a strong enough balance sheet, income statement, and cash flows to receive an investment-grade rating will almost certainly opt to have its securities rated by one of the major rating agencies. While it does cost money to receive a credit rating, the interest that it will save by issuing investment-grade securities versus unrated securities will more than cover this cost. Thus, the unrated securities are almost certainly junk bonds, but they could be anything from a BB security to a D-rated security. As these bonds account for a significant portion of the portfolio, it is difficult to evaluate the actual risk here.
While this risk can be significantly reduced by including a large number of bonds in the portfolio, the fund’s sponsor does not state exactly how many issuers are represented in the bond portion of the portfolio. The fund has 814 holdings, but this count includes common stocks as well. Hopefully, the fund has only limited exposure to any individual issuer, which is necessary to ensure that any default will only have a negligible impact on the portfolio as a whole.
In my last article on this company, I noted that the Calamos Strategic Total Return Fund had a number of large technology companies included among its largest holdings. This continues to be the case today, as we can clearly see from looking at the fund’s portfolio. Here are the largest positions:
We see here sizable allocations to Apple ( AAPL ), Microsoft ( MSFT ), Amazon ( AMZN ), Alphabet ( GOOGL ), NVIDIA ( NVDA ), and Meta Platforms ( META ). These companies have generally delivered outsized performance this year due to the mania surrounding artificial intelligence. I discussed this in a blog post from earlier this year. However, now we are starting to see other companies catch up. For example, it might be surprising to learn that Exxon Mobil ( XOM ) has actually outperformed Apple over the past year:
When we add in Exxon Mobil’s much higher dividend yield, the difference becomes even more stark. This goes back to my statement in the introduction about short-duration stocks, such as Exxon Mobil, are probably going to be better holdings than long-duration technology stocks that have already been run up to nosebleed levels. This is especially true when we consider that the American consumer seems to be weakening, which will put pressure on the revenue of companies that are highly dependent on consumer discretionary spending like Apple.
Curiously though, the fund seems to be increasing its exposure to long-duration assets. Over the past four months since we last discussed this fund, the Calamos Strategic Total Return Fund has removed UnitedHealth Group ( UNH ), Johnson & Johnson ( JNJ ), and T-Mobile ( TMUS ) from its largest positions list. In their place, we have Meta Platforms ( META ), Eli Lilly ( LLY ), and Tesla ( TSLA ). While I have few comments on whether or not all of these changes were good, I can think of a few companies that would probably be better short-term holdings for the fund, such as pretty much anything in the traditional energy sector. After all, there is currently predicted to be a multi-million-barrel shortage of crude oil in the third quarter that will almost certainly drive up gasoline prices and further strain an American consumer who has already been crushed by the inflation and declining real wages of the past two years. Energy stocks should benefit from this, especially because they are actually lagging their historical beta to Brent crude oil right now:
Zero Hedge/Market Ear
Thus, stocks in that sector have a high probability of outperformance relative to the high-duration technology stocks over the next few months, just like we saw back in 2022. For some reason, the fund’s management is missing this and buying up the technology stocks that rallied earlier this year and are now beginning to correct.
Leverage
As is the case with most closed-end funds, the Calamos Strategic Total Return Fund employs leverage as a way to boost its total returns. I discussed how this works in my last article on the fund:
In short, the fund is borrowing money and using that borrowed money to purchase stocks and bonds. As long as the purchased assets produce a higher return than the interest rate that the fund has to pay on the borrowed money, the strategy works pretty well to boost the effective return of the portfolio. As this fund is capable of borrowing money at institutional rates, which are considerably lower than retail rates, this will usually be the case.
However, the use of debt in this fashion is a double-edged sword. This is because leverage boosts both gains and losses. As such, we want to ensure that the fund is not employing too much leverage because that would expose us to an excessive amount of risk. I typically like to see a fund’s leverage under a third as a percentage of its assets for this reason.
As of the time of writing, the Calamos Strategic Total Return Fund has levered assets comprising 32.50% of its portfolio. This is a bit lower than the 33.89% ratio that the fund had the last time that we discussed it, which is a positive sign. After all, the fund appears to be reducing its leverage with the passage of time. That is good considering that the market appears to be underestimating the risk of interest rates right now and the Federal Reserve appears committed to its “higher for longer” mantra. That raises the risk of employing leverage since the fund needs to earn higher returns to overcome the cost of debt and this is not as easy as it used to be. For the most part, the fund’s leverage appears to be okay here, but I will not complain if it continues to reduce its effective leverage going forward.
Distribution Analysis
As mentioned earlier in this article, the Calamos Strategic Total Return Fund has the objective of providing its investors with a high level of total return. However, one of the avenues through which it aims to achieve that total return is by receiving current income. The bond allocation in particular is good for this. In addition, the fund also aims to generate capital gains from the common stocks in the portfolio. A defining characteristic of closed-end funds is that they collect all of the investment profits that they generate and pay them out to the shareholders, net of fund expenses. The basic goal is to maintain a relatively stable asset base over time. As the current yield on junk bonds is quite high and stocks historically deliver solid capital returns, we might expect that this process will result in this fund paying out a very high distribution yield to its investors. This is especially true when we consider that the fund is employing leverage as a means to boost its total returns.
It is certainly the case that the fund has a respectable distribution yield, as it currently pays a monthly distribution of $0.1025 per share ($1.23 per share annually), which gives it an 8.27% yield at the current price. This fund has been remarkably consistent with its distribution over time, as it has been raising it since early 2012:
This is one of the best track records for any closed-end fund, and this is one of the few funds that has not had to cut its distribution in response to the rising interest rate environment that began early last year. As such, it seems likely that the fund will appeal to anyone who is seeking a safe and secure source of income to use to pay their bills or finance their lifestyles.
As is always the case though, it is critical that we ensure that the fund is actually capable of affording the distribution that it pays out. After all, we do not want to be the victims of a distribution cut since that would reduce our incomes and almost certainly cause the fund’s share price to decline.
Fortunately, we have a very recent document that we can consult for the purposes of our analysis. As of the time of writing, the fund’s most recent financial report corresponds to the six-month period that ended on April 30, 2023. This is a much newer report than the one that we had available to us the last time that we discussed this fund. This is a good thing as it should give us a good idea of how well the fund was able to take advantage of the artificial intelligence mania earlier this year to generate some capital gains. It will also increase our visibility into how well the fund is sustaining its current distribution, which is always nice.
During the six-month period, the Calamos Strategic Total Return Fund received $22,237,524 in dividends and $21,241,378 in interest from the assets in its portfolio. After we subtract out the money that the fund had to pay in foreign withholding taxes, as well as the fact that some of those interest payments were classified as a return of principal, we see that it had a total investment income of $39,150,928 during the period. This amount was insufficient to pay the fund’s expenses, which is very surprising. It reported a net investment loss of $2,307,554 during the period. This was obviously not nearly enough to pay any distributions, but the fund still paid out $98,076,123 to its investors over the period. At first glance, this is almost certainly going to be concerning as the fund did not have sufficient net investment income to cover its distributions.
However, there are other methods that can be employed to obtain the money that the fund needs to cover its distributions. For example, it might be able to earn some capital gains that could be paid out to the shareholders. Fortunately, the fund did have some success at this task, as it reported net realized gains of $32,223,837 and had another $153,227,355 net unrealized gains. This was more than sufficient to cover the distribution and overall, the fund’s net assets increased by $101,833,583 after accounting for all inflows and outflows over the period. However, it is important to note that the fund paid out more than its net realized gains and net investment income. It was only because of the net unrealized gains that the fund covered its distributions. This is fine in many circumstances, but it is important to keep in mind that unrealized gains can be erased fairly quickly. As such, it is usually best for the fund to only pay out its net realized gains and net investment income.
Valuation
As of September 18, 2023 (the most recent date for which data is available as of the time of writing), the Calamos Strategic Total Return Fund has a net asset value of $14.56 per share but the shares currently trade for $14.88 per share. This gives the fund’s shares a 2.20% premium on net asset value at the current price. That is substantially higher than the 0.47% premium that the shares have had on average over the past month, and frankly paying a premium for any closed-end fund is not usually a great idea. As such, it is probably best to wait for the shares to drop a bit in price before buying.
Conclusion
In conclusion, the Calamos Strategic Total Return Fund has some good characteristics. In particular, the fact that it is a blended fund allows it to better take advantage of the high-interest rate environment than a pure common stock fund could. After all, bond yields are respectable enough right now that all an investor really needs to do is purchase bonds and hold them to maturity. The portfolio may not be the best for the current environment, though, as the fund seems to be betting on the artificial intelligence mania going on forever when high interest rates are not really conducive to this. The fund’s current distribution is probably in good shape assuming that it locks in some of those unrealized gains before a market turn. The fund’s current valuation is also a bit high, which is disappointing.
For further details see:
CSQ: This Blended Fund Has Appealing Features, But Its Price Is Too High