Written by Nick Ackerman, co-produced by Stanford Chemist
The Calamos Strategic Total Return Fund (CSQ) offers investors an attractive blend of convertible exposure and common equity exposure. Equities dominate the largest allocation of the fund’s portfolio, led by the tech sector. Though the allocation to tech isn’t egregiously large overall. In fact, the allocation of tech is smaller than that of the S&P 500. The strong returns since the GFC have also given investors a few distribution boosts since then, with the last dividend increase happening earlier this year.
CSQ seeks “total return through a combination of capital appreciation and current income.” Its investment strategy is quite simple: “investing in a diversified portfolio of equities, convertible securities and high yield corporate bonds.”
Essentially, the investment managers can posture the portfolio in whatever particular composition they deem the most attractive. That can result in some superior returns if they get it right. While the opposite is just as true, the current management team has been able to deliver more than reasonable returns. Calamos also has experience in the convertible space, with its line-up of CEFs offering exposure to these investment instruments. That being said, CSQ is one of their funds that actually has the least exposure to this space.
Convertible stock can be beneficial for some investors, as they have features of both equities and fixed-income. This means they can also be potentially more volatile than regular fixed-income instruments, as the conversion feature results in movement based on the equity of a company. However, that also potentially allows for upside when a conversion takes place – all the while collecting a fixed interest rate on their holding. Typically, retail investors do not get exposure to these investments, as they aren’t traded on exchanges. They are level 2 assets though, so liquidity value is reliable.
CSQ is a rather large fund with just over $3 billion in total managed assets. The fund does utilize leverage, which can increase volatility. Leverage was last at 30.23% of assets. The bulk of this leverage is through borrowings at a rate of LIBOR plus 0.80%. This varying rate should bode well now that interest rates have been set to 0% by the Fed.
The other borrowings are from a few offerings of preferred stock. These are mandatory redeemable preferred shares with dividend rates of 3.70-4.24%. These are not publicly traded, and are therefore not available to most retail investors.
The expense ratio for CSQ is 2.81%, excluding leverage, and this drops expenses to 1.54%. This is typically on the higher side for equity funds, but the mixture of assets and convertible dealings can make this acceptable to some.
Track Record Of Strong Performance
On a YTD basis, the fund has done rather well as compared to where some other funds are trading. Though the drop in March definitely did not spare CSQ from the carnage.
More recently, the correction in the tech space has impacted CSQ. At one point, the fund was up double digits on both a share price and NAV basis.
Even more impressive is its longer-term track record. On a total NAV return basis, the fund has been able to return 13.69% for the period ending August 31st. For the share price total return, this outpaced at a return of 14.9%.
(Source: Fund website)
Going back a bit further, total returns for the annualized 15-year period was 8.99% on the share price and 8.76% on an NAV basis. Those are some quite solid performance numbers the managers have been able to put up. That also provides us performance through two recessions and stock market crashes. Which, does potentially warrant higher fees if they can replicate this going forward.
CSQ isn’t necessarily beating the S&P 500’s performance, but it isn’t expected to either as a hybrid fund.
What is quite interesting about this fund is that for the last several years, its discount has disappeared. As we saw such an outperformance in share price relative to the NAV, this is only natural to have occurred over the last 10 years. However, it is worth noting that the disappearance of the discount hadn’t taken place until just the last few years. Before this, CSQ could be bought at some large discounts. Now, we are lucky to get brief opportunities to add during sharp sell-offs like those seen in March and Q4 2018.
This being the case, CSQ’s 2.57% discount is attractive compared to its 1-year average of 1.49%. However, backing this out further, we see the 5-year average discount is 5.26%. This does make me cautious going out to say this is a buy right now at today’s levels. For an investor with a longer-term outlook though, I certainly could see adding shares or starting an initial position.
Distribution – Expanding NII Coverage Could Occur, But Not Necessary To Continue Paying Current Rate
CSQ’s latest Semi-Annual Report is for the period ending April 30th, 2020. As we now know, the Fed has dropped interest rates to 0%. Since the bulk of the fund’s borrowings are primarily based on LIBOR, this should bode well for increasing net investment income. However, given that this report is from such a short period of time afterward, we don’t see exactly what the end result will be.
What we can see though, is that interest expense for last year’s report was $9,422,349 for the same period. The outstanding balance was $668 million. Fast forward to this year, and the fund reported interest expenses of $7,359,908 on $677 million in borrowings. That does indicate that it is having a positive affect.
All of that being said, CSQ’s NII came out right around the same amount, as other expenses offset the benefit. Ultimately though, as a fund with so much exposure to equities – we will derive a significant portion of the distribution from capital appreciation anyway. An increase in NII still wouldn’t hurt!
That being the case, even after the collapse of the market in March, at the end of April, the fund was still showing ~$90 million in unrealized appreciation. Since then, assets have increased by over $300 million.
(Source: Semi-Annual Report)
That large buffer of unrealized appreciation on the portfolio is likely what caused management to boost their distribution heading into this year. This increase came in February, so it does make me curious if they would have gone through with this knowing what March would hold.
The latest distribution is $0.0925 per share paid monthly, or a dividend yield of 8.37% on the share price. Due to the fund’s close trading range to its NAV, the NAV distribution rate comes to a similar 8.16%.
Due to the fund’s tight discount and fluctuation between slight premiums, investors are sometimes benefited from reinvesting distributions automatically back into more shares. Investors receive a discount in that they either receive shares at NAV or 5% below market price.
Last year, CSQ’s distributions came out to around 78% classified as long-term capital gains. This can be beneficial in a taxable account as a way to reduce tax obligations. Generally, LTCGs are taxed at a lower rate than ordinary income.
(Source: Semi-Annual Report)
Holdings – Heavy Equities And Overweight Tech
As mentioned above, common equities make up the largest portion of CSQ’s portfolio at 60.8%. Convertibles come in second at 20.8% of its portfolio, while corporate bonds make up 13.5%. After that, it is a small mixture of bank loans, cash, preferred stock, synthetic convertibles, options and warrants. The overwhelming majority of the fund’s portfolio will be dictated by returns in equities, convertibles and bonds though, even adding up all these other minor allocations.
(Source: Fund website)
Tech makes up 23.1% of its portfolio. As previously mentioned again, this is actually lower exposure to tech than what is supposed to be a broader index, the S&P 500 Index. The other sectors of exposure are consumer discretionary at 13.9%, communications services at 12.7%, healthcare at 12.7% and financials at 9.8%. Although those are the largest allocations in order, the fund still adds a rather overall healthy mixture of sector exposure.
This broad-based exposure can potentially be helpful for an investor wanting to put money to work without significantly altering their sector exposure. This hybrid structure should also bode well over the long term through the benefits of diversification.
(Source: Fund website)
To help further add to the stability of its portfolio, CSQ invests in some of the best-known companies out there.
(Source: Fund Website)
Large-cap tech names show up in its top ten, as we frequently see in many other funds. However, some other areas of the market are still represented as well. For those that are very hesitant to invest in the typical go-to tech behemoths, this particular fund might be a pass for those. Apple (AAPL), Microsoft (MSFT), Amazon (AMZN), Alphabet (GOOG) and Facebook (FB) all make the top list and comprise 17.4% of the portfolio. That being said, we have seen other funds place a much greater focus on these positions.
Besides the popular tech names, we see a company like Visa (V) that has been able to exceed market expectations for earnings, at least hinting that it isn’t as damaged as originally thought. Though also conceding that it isn’t immune to the damages of the pandemic, with the company’s earnings still reflecting some contraction rather than growth – growth in revenue and EPS that seems to become easy to achieve in the other tech-related positions.
After V, the fund has exposure to UnitedHealth Group (UNH), which is a healthcare giant operating in the insurance subsector. The last time the company reported was back in July – it didn’t blow results away, but the company is certainly holding its own during this environment. Companies that are able to show any growth in revenue or EPS in a recession are some of those that I want in my portfolio. That being said, we all know that healthcare is usually a contentious topic, especially during an election year. At least for this year, the stability in the healthcare space has won out against rhetoric on healthcare; this is reflected by healthcare showing a relatively flat YTD performance.
CSQ remains a strong contender for a space in investors’ portfolios based on its track record. However, the slim discount and top exposure to the tech giants might make some investors pause. While I understand some hesitation, if an investor has a longer-term holding, I don’t necessarily see now as a bad time to pick up some shares. Additionally, some investors may wait as we enter fall. The election and potential COVID-19 spreading could induce lockdowns again, which, in turn, might present an even better buying opportunity. Due to the fund’s leverage, we can see some particularly deep drops. Though, as we typically witness, the share price drops in an even more spectacular manner. Those drops in March made CSQ hit an extremely wide discount of 17.61% on the March 18 close.
An investor that is able to withstand volatility for the longer-term potential also gets to collect an attractive monthly distribution. The current rate comes out to an enticing 8.37%. While fund had cut shortly after the GFC, it has now increased several times. A distribution cut during 2008/09 isn’t also particularly worrying or cause for concern.
Profitable CEF and ETF income and arbitrage ideas
At the CEF/ETF Income Laboratory, we manage ~8%-yielding closed-end fund (CEF) and exchange-traded fund (ETF) portfolios to make income investing easy for you. Check out what our members have to say about our service.
To see all that our exclusive membership has to offer, sign up for a free trial by clicking on the button below!
Disclosure: I am/we are long CSQ, UNH, MSFT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.