Convertibles: Know When to Fold 'Em

This column was originally published on RealMoney. It's being republished as a bonus for TheStreet.com 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 Quote). 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

Source: BigCharts.com

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.