Q&A JOHN P. CALAMOS: "IF A STOCK FALLS OUT OF BED, THE CONVERTIBLE SHOULD HOLD UP"

With the stock market’s big bull run over the past decade, the chances of piquing an investor’s interest in convertible bonds has been about as likely as a Texas snowstorm in August.

After all, convertibles — which allow investors to convert bonds into shares of the issuing company’s stock, usually at a preset price — are designed to offer some of the capital appreciation potential of stocks while supplying some of the safety and yield of bonds. And few individual investors have been willing to back away from a market that’s produced 20%-plus annual returns over the last three years.

But the stock market’s increasing volatility and recent retreat –down 9.7% from last month’s high as measured by the Standard & Poor’s 500 Stock Index through Aug. 4 — are making the extra safety of convertibles attractive.

That’s benefiting veteran managers like John Calamos, who’s been analyzing these hybrid securities for more than two decades and manages more than $3 billion in convertibles for insurance companies, pension funds, pooled individual accounts and five mutual funds at his eponymous firm in Naperville, Ill.

And while junk bonds have attracted widespread attention for their double-digit returns over the last three years, convertible bonds were actually the best performing fixed-income asset class from 1993 through last year. Such funds gained 12.5% annually, vs. 11.4% for junk funds, according to researcher Morningstar Inc. in Chicago.

Q How do convertibles fit in to the current market environment?

A Our view of the market is constructive. We think it’s a time to do your homework and look at company specifics. We also agree with many analysts that there are certain sectors of the market such as technology and large-cap growth stocks that seem very extended and where valuations don’t make sense. Those factors combined make for a very volatile environment.

We view ourselves as a risk manager and convertibles allow us to control risk better than most other ways that we know. Convertibles also fit well now in the sense that the bond market seems to have stabilized. Therefore the embedded bond value of the security seems to be secure.

Q But convertibles fell dramatically during the 1987 crash.

A The broader market was down a lot more than the S&P 500 and convertibles did better than the underlying convertible stock universe. Convertibles reflect the broader market. The conclusion to most of us who have been in the convertible market not only through 1987, but 1979 to 1981 and 1974 is that convertibles did their job on the downside. In 1987, investment-grade convertibles held up very well, whereas below- investment-grade convertibles did not, which is what you would expect.

Q So one could still think of convertibles as like buying options as insurance against a market drop?

A That’s an excellent analogy. In a convertible portfolio you have an insurance option for that disaster that you hope doesn’t occur. If a stock falls completely out of bed, the convertible bond should hold up and protect you on the down side. It’s hard to predict what might happen, but it makes sense to look at another large convertible market like Japan, which at one point represented about 40% of the global convertible bond market. In 1989 Japan’s stock market peaked and was cut in half. Convertible bonds have become the best-performing asset class in Japan since 1978, according to Yamaichi Research Institute, because the bonds paid off.

Q Hasn’t the growth of the convertible bond market made it more difficult to spot bargains?

A Because the convertibles market is a more institutional market, it’s also more sophisticated. We don’t see the gross overvaluations and undervaluations that we used to see in the past. It’s a much fairer marketplace and gives us a lot of flexibility to structure portfolios for different investment objectives. The market has also become more liquid as equity income funds and hedge funds incorporate convertibles into their portfolios.

Over the last two years, we’ve also seen record new issuance levels. Last year, companies issued $33 billion in new convertibles, vs. $30 billion in 1996. And $25 billion in new issues came to market in the first half of this year, so we are on track for another record.

Of course, the offset of that is that calls and redemptions are also up because of the strong equity market. But the convertible market continues to expand. There are around $400 billion issues outstanding in the global convertible market. U.S. issues represent about $160 billion of that total.

Q How does the higher number of calls affect the way you manage your portfolios?

A Most convertibles are issued with three- to five-year call protection. As the price of the underlying stock goes up, a company will force the bond to be converted to its common stock. That’s not necessarily a bad event since companies typically do it when the convertible is well in the money. It forces you to take a profit and to rebalance the portfolio.

Q How are investors using convertibles today?

A We’re seeing many investors include convertibles as part of their fixed-income allocation, since they have bond attributes and a performance edge. That’s a very significant trend among insurance companies and corporate and public pension funds.

Q Which industry sectors of the convertibles market appeal to you?

A Our main thrust has been to stay away from commodity-based sectors, like energy, where our weighting is probably one-third of energy issues in a typical convertible index such as the First Boston Convertible Securities Index. We’ve been overweighted in financials and in consumer cyclicals and staples.

An interesting small company we like is Whole Foods Market Inc., which sells organically grown foods in the affluent parts of cities. They’ve been on an acquisition trail, and have a convertible trading at $34.75. It’s a zero coupon bond (zeros of March 2, 2018) that allows you to put it back to the company in five years for a 7% yield. If the stock does well, you should get about 50% to 60% of the upside of the underlying stock. With the put provision, we believe you only have 25% to 30% of the downside — a very favorable risk/reward ratio in a small-growth company that we believe is going well.

Q What other sectors interest you?

A We have been light on technology, but we still like certain areas such as Clear Channel Communications Inc. and Qualcomm Inc. Qualcomm has been very successful in developing CDMA (code division multiple access) technology, a digital wireless switching system. Its convertible preferred (52/3s of March 1, 2012) is trading at $52.50 and yields 5.5%. We estimate you can participate in about 70% of the upside of the underlying stock, with only about one-third of the downside.

Clear Channel Communications is a diversified broadcasting and cable TV company that holds interests in radio stations in Australia, New Zealand and Spain. It has an attractive convertible that currently trades at $110 or a little above par. At that price we think the convertible bond (2 5/8s of April 1, 2003) has 70% of the stock’s upside, but more risk than Qualcomm — maybe 40% to 45% — on the downside. The stock doesn’t pay any dividend, but the bond currently yields about 2.5%.

Q Which sectors are you lightening up?

A We’re underweighting energy. But we think Diamond Offshore Drilling Inc., which is involved in drilling deep oil and gas wells in the Gulf of Mexico, is an exception and its convertible bond (32/3 of 2007) is an excellent way to play it. The bond was trading as high as $150 to $160 last year. As the energy sector has sold off, the convertible has dropped to around $106 with a current 3.5% yield. That should give you 50% to 60% of the stock’s upside. Its investment grade rating of A- by S&P and Baa2 by Moody’s offers good downside safety.Continued from Page 27

A Most convertibles are issued with three- to five-year call protection. As the price of the underlying stock goes up, a company will force the bond to be converted to its common stock. That’s not necessarily a bad event since companies typically do it when the convertible is well in the money. It forces you to take a profit and to rebalance the portfolio.

Q How are investors using convertibles today?

A We’re seeing many investors include convertibles as part of their fixed-income allocation, since they have bond attributes and a performance edge. That’s a very significant trend among insurance companies and corporate and public pension funds.

Q Which industry sectors of the convertibles market appeal to you?

A Our main thrust has been to stay away from commodity-based sectors, like energy, where our weighting is probably one-third of energy issues in a typical convertible index such as the First Boston Convertible Securities Index. We’ve been overweighted in financials and in consumer cyclicals and staples.

An interesting small company we like is Whole Foods Market Inc., which sells organically grown foods in the affluent parts of cities. They’ve been on an acquisition trail, and have a convertible trading at $34.75. It’s a zero coupon bond (zeros of March 2, 2018) that allows you to put it back to the company in five years for a 7% yield. If the stock does well, you should get about 50% to 60% of the upside of the underlying stock. With the put provision, we believe you only have 25% to 30% of the downside — a very favorable risk/reward ratio in a small-growth company that we believe is going well.

Q What other sectors interest you?

A We have been light on technology, but we still like certain areas such as Clear Channel Communications Inc. and Qualcomm Inc. Qualcomm has been very successful in developing CDMA (code division multiple access) technology, a digital wireless switching system. Its convertible preferred (5 3/4s of March 1, 2012) is trading at $52.50 and yields 5.5%. We estimate you can participate in about 70% of the upside of the underlying stock, with only about one-third of the downside.

Clear Channel Communications is a diversified broadcasting and cable TV company that holds interests in radio stations in Australia, New Zealand and Spain. It has an attractive convertible that currently trades at $110 or a little above par. At that price we think the convertible bond (2 5/8s of April 1, 2003) has 70% of the stock’s upside, but more risk than Qualcomm — maybe 40% to 45% — on the downside. The stock doesn’t pay any dividend, but the bond currently yields about 2.5%.

Q Which sectors are you lightening up?

A We’re underweighting energy. But we think Diamond Offshore Drilling Inc., which is involved in drilling deep oil and gas wells in the Gulf of Mexico, is an exception and its convertible bond (3 3/4s of 2007) is an excellent way to play it. The bond was trading as high as $150 to $160 last year. As the energy sector has sold off, the convertible has dropped to around $106 with a current 3.5% yield. That should give you 50% to 60% of the stock’s upside. Its investment grade rating of A- by S&P and Baa2 by Moody’s offers good downside safety.

Vite

John P. Calamos, 57, president and chief investment officer, Calamos Asset Management Inc., Naperville, Ill.

Calamos Convertible Fund (assets, $124 million): year-to-date, 10.9%; 1-year, 13.1%; 3-year, 18.6%; 5-year, 14.9%

Lipper Convertible Securities Funds index: year-to-date, 3.7%; 1-year, 6%; 3-year 13.4; 5-year 11.3%

Calamos Growth and Income Fund (assets, $18.3 million): year-to-date, 13.7%; 1-year, 18.2%; 3-year, 22.6%; 5-year, 16.2%

Standard & Poor’s Midcap 400 Index: year-to-date, 4.3%; 1-year, 11.3%; 3-year, 20.8%;

5-year, 17.3%

Figures are as of 7/31/98 and reflect average annual returns for periods over one year.

Sources: Calamos,

Lipper Analytical Services Inc.,

Morningstar Inc.