Convert and Sleep Better

John P. Calamos was a retail broker in the 1970s when he first began using convertible bonds in clients' portfolios. Convertibles were somewhat exotic then, but they struck Calamos as an antidote to a financially turbulent decade marked by a lousy stock market and double-digit interest rates. Nice timing. Converts — bonds that can be turned into a stock at a future date — posted the best performance of any asset class in the 1970s, according to Calamos.

The son of a Greek immigrant grocery owner, Calamos was so successful with convertibles that when he launched his own money management business in 1977, they were the core strategy. Though interest rates aren't now in the double digits, the market is certainly in the doldrums. Which is one reason why convertible bonds have been growing in popularity. Reps interested in some of the upside of equities without the potential downside look to converts. Indeed, Calamos Asset Management, based in Naperville, Ill., has enjoyed spectacular growth. Last year, for example, its mutual fund assets quadrupled to $3.7 billion, according to Strategic Insight, a research firm.

In addition to convertible offerings, Calamos has equity portfolios that have posted strong long-term performance, particularly its Midcap Growth Fund (see table). Calamos funds now have $10.5 billion under management, roughly 300 percent more than five years ago.

Calamos has offerings in mutual funds and separate account programs, and is available on the platforms of Merrill Lynch, Morgan Stanley, Salomon Smith Barney, Prudential and Wachovia (formerly First Union), among others. Institutions comprise the biggest chunk of assets, but the mutual fund and separate account businesses are growing faster.

Last year, a record $105 billion was raised in the convertible bond market, and this year looks even better. [Companies, usually somewhat cash-starved and asset-light, issue convertible bonds to raise money a bit more cheaply than they could by floating traditional bonds — the option but not the obligation to convert the bond into stock at a later date sweetens the deal for investors.]

The asset class is a product that is sold, not bought, which has limited its popularity among reps. Converts can be difficult for clients to understand. And some reps have trouble placing them in an asset allocation puzzle. Nevertheless, as convertibles have turned in better performances relative to most common stocks in the last two ugly years, they have attracted attention. “I've never seen this much interest,” says John Calamos.

Convertibles can post some of the sexy capital gains of equities but, in a sluggish market such as this, the income paid by the bond acts as a cushion. If the underlying equity increases in value, the shareholders get a premium above the conversion level.

Calamos' strategy has worked well. Brad Pihl, senior vice president of investments at UBS PaineWebber, has worked with the firm since 1995. “They've done what I've expected them to do for my type of client base,” he says, adding that investments averaged an annual return of roughly 10 percent.

Calamos manages the portfolios with his nephew Nick Calamos, and together they devised a quantitative investment process that breaks down convertibles into various components to exploit market inefficiencies.

Among other things, Calamos examines credit ratings to uncover improving credit quality that can boost a convertible's value. It also tracks the underlying value of the equity, looking at cash flow and evaluating management.

“We look at factors that indicate when to take profit even when the fundamentals look good,” says Calamos.

This is important, given some of the risks the sector poses. Telecoms were big issuers of converts (think WorldCom), as were tech companies. Citing the telecom bust and September 11, hedge fund manager Ken Lipper was forced to write down, by $315 million, the value of two of his convertible arbitrage portfolios. Of course, Calamos doesn't amp up on leverage the way hedge funds do.

Still, the sector is hot. Fidelity, Putnam and Oppenheimer have recently added convertible bonds. However, Calamos has experience on his side. “There are a lot of stock pickers with good long-term track records,” says Morningstar analyst Bill Harding. “But it's hard to find the kind of experience and performance in convertibles that Calamos brings to the table. They've been doing it longer than anybody.”