Top Down and Bottom Up: The Case for Convertibles Is Strong

Top-Down and Bottom-Up: The Case for Convertibles is Strong

Jon Vacko, CFA, and Joe Wysocki, CFA

Summary Points:

• We believe Fed easing, resilient economic growth, and lower inflation create a hospitable environment for risk assets, including the small and mid-cap companies well represented among convertible issuers.
• We're prepared for choppy markets as investors react to economic data reports and grapple with the uncertainties of the presidential election.
• We employ multiple levers to manage risk, including maintaining our long-standing emphasis on balanced convertibles and adhering to a disciplined and fundamentally driven approach. We have also increased the fund's allocation to higher-quality credits.
• There may be a seasonal slowdown in convertible issuance in the fourth quarter, but we expect the market to remain healthy with solid issuance next year and beyond.

Equity markets continued their upward trajectory in the third quarter, overcoming a sharp pullback in August to finish near record highs again. US economic data continues to normalize, with growth remaining resilient and inflation trending lower. Additionally, the Federal Reserve lowered interest rates for the first time this cycle, sending a strong message to the market with a 50 basis points cut.

We are pleased to see these developments and are optimistic they can sustain the positive trajectory for risk assets. However, we also believe it is prudent for investors to anticipate continued short-term volatility, as evidenced by the recent spike in the Cboe Volatility Index (VIX) to levels that are typically only seen during extreme market stress. Markets will closely scrutinize each incoming data point and quickly adjust to the latest economic indicators. Moreover, we are only a few weeks away from a contentious US presidential election that will have far-reaching implications for many areas of the economy.

Given this backdrop, we believe the strategic case for convertibles remains strong. Within the Calamos Convertible Fund (CICVX), we emphasize balanced convertibles that offer attractive structural risk/reward characteristics that can provide upside potential to equities with downside risk mitigation.

Historically, lower interest rates have been a tailwind for small and mid-cap companies, which are well-represented in the convertible universe. We are positioning the fund to benefit from a potential broadening of equity market leadership beyond mega-cap names, which could be particularly beneficial for these convertible issuers. At the same time, we have also increased our allocation to higher-credit-quality convertibles.

Technology and consumer discretionary are CICVX's largest sector allocations. We favor companies that can execute well through a variety of market environments, with improving margins and free cash flow, accelerating returns on invested capital, and growing their intrinsic value. We also see opportunities tied to cyclical and secular themes that can serve as tailwinds to individual corporate performance. These include companies advantageously positioned as businesses seek solutions to higher labor, manufacturing, and interest costs in the current economic environment. We are also investing in companies exposed to artificial intelligence, productivity enhancements, and cybersecurity trends, where we see opportunities in existing convertibles and expect more to come.

Convertible new issuance remains robust, with year-to-date global volumes of $82 already surpassing last year's total, even with three months remaining in 2024. We are encouraged by the more favorable terms compared to prior years, including higher coupons, lower conversion premiums, and a greater proportion of investment-grade credits entering the market. (See "Convertible Market Trends: Looking Under the Hood" for more information on the convertible market.)

As a significant amount of debt matures across all bond markets in coming years, and with the potential of a prolonged higher interest rate environment compared to prior cycles, convertibles present a compelling cost-saving advantage for a broad set of companies. Additionally, convertibles have historically provided essential growth capital for leading small- and mid-cap companies throughout the business cycle. Although there may be a seasonal slowdown in the fourth quarter as companies seek clarity on the US fiscal situation, we believe these factors will contribute to strong issuance trends into next year and beyond.