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Convertibles: Know When to Fold 'Em

This column was originally published on RealMoney . It's being republished as a bonus for readers.

Knowing when and how to sell might be the most difficult part of managing a portfolio.

Earlier this week, I began to unwind a position in the Calamos Convertible Opportunities and Income Fund (CHI). I have owned the fund for clients since shortly after its IPO in early 2003.

Convertible bonds convert into common stock at a particular price. Usually these bonds are issued with a conversion price much higher than that of the underlying common stock. In a few years, if the stock moves higher, holders might convert their bonds into common stock. A big draw is that as the stock moves higher in price, so does the bond, but if the stock trades lower, the convert trades more like a bond. Buyers need to do their homework with individual issues.

In fact, buying individual issues is very difficult for do-it-yourself investors and a lot of portfolio managers. If a manager can get access to a great bond offering from the Acme Anvil Company, he can buy what he needs for clients, but as new clients come on board, he may have a tough time buying more or finding a suitable substitute.

Another problem for individual investors in convertible bonds is selling them. A brokerage is likely to give a very low bid for $25,000 or even $50,000 worth of a bond. This is because the firm may not be able to sell it quickly to someone else.

This is where a closed-end fund such as Calamos Convertible Opportunities can come in handy. Calamos is just about the best fund manager in the business for convertible bonds.

A lot of attention is paid to the premium or discount to net asset value of closed-end funds. While this is important, I think that big changes in the premium or discount are more important. Calamos Convertible has traded at a large premium to NAV for a long time, and investors haven't really been hurt by paying it. The premium has held steady, and the fund has yielded 8% to 9% while I have held it.

Calamos Convertible Opportunities & Income Fund
Click here for larger image.
Source: Calamos Financial Services

There are several reasons why I cut my position in half. First is the recent slow rolling over in the premium that, on the chart, looks like the downtrend you would see on the chart of a stock.

Another issue is that the fund is interest rate sensitive. If the Federal Reserve has its way, the middle of the curve will be quite a bit higher, and that could hurt Calamos. I also believe that the reissuance of 30-year Treasuries in February could push rates higher as well.

Calamos vs. 10-Year Treasury Yield Index

My last point of concern has to do with investor sentiment toward Calamos Convertible, and I think this concept applies to most closed-end funds. The fund has such a large premium because investors are quite fond of it. If rates do move higher, not only could its NAV drop, the premium could drop faster, magnifying a potential drop in price.

Given all of this, I think it's a good time to cut back on positions in the fund.
At the time of publication, Nusbaum was long CHI in client accounts, although positions may change at any time.

Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, Ariz., and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback; click here to send him an email.

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