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Is It Time To Buy Convertible Bond CEFs?

Summary Convertible bond CEFs have been hit hard lately, resulting in historically large discounts. Convertible bond CEFs offer enticing income while you wait for the sector to recover. My pick is NCZ, which is currently selling at a large discount and provides a distribution of 12%. In February of this year, I wrote an article advising investors to beware of convertible bond closed end funds (CEFs). At that time, I cautioned that premiums could disappear. As it turned out, my fears was well founded. In July of this year, the premiums morphed into large discounts. After the selloff, I now believe some of these CEFs are selling at bargain levels. Part of my reasoning is based on the currently large negative Z-scores associated with these CEFs. Z-score is a metric popularized by Morningstar and is a measures how far a discount (or premium) is from the mean discount (or premium). The Z-score is computed in terms of standard deviations from the mean so it can be used to rank CEFs. A negative Z-score indicates that the current discount is larger than the average discount over the past year. A Z-score more negative than minus 2 is relatively rare, occurring less than 2.25% of the time. A good source for reviewing Z-scores is the CEFAnalyzer website. Most of the convertible CEFs currently have Z-scores more negative than minus 2. Before jumping into analysis of the risk versus rewards of convertible CEFs, I will recap some of the characteristics of this asset class. A “convertible security” is an investment that can be converted into a company’s common stocks. A company will typically issue a convertible security to lower the cost of raising money. For example, many investors are willing to accept a lower payout because of the conversion feature. The conversion formula is fixed and specifies the conditions that will allow the holder to convert into common stock. Therefore the performance of a convertible is heavily influenced by the price action of the underlying stock. As the stock prices approaches or exceeds the “conversion price” the convertible tends to act more like an equity. If the stock price is far below the conversion price, the convertible acts more like a bond or preferred share. Convertible bond CEFs usually contain a mixture of convertible securities and high yield bonds. The attraction of convertible CEFs is that they offer upside potential with some protection on the downside. Granted that with a portfolio of high yield bonds and convertibles the downside protection is limited. However, over the long run, the fund manager seeks to obtain the “sweet spot” between fixed income and equity that will enable him to outperform his peers. The funds that were analyzed in my previous article are summarized below. AGIC Convertible and Income (NYSE: NCV ). Over the past 5 years, this CEF has sold mostly at a premium, sometimes as high as 14%. It was not until the second half of 2015 that the fund began selling at a discount. The five year average has been a premium of 7.5% and the 1 year average was still a premium of 5.7%. The fund is now selling at a discount of over 10% and has a Z-score of negative 2.55. The portfolio consists of a combination of convertible bonds (58%) and high yield bonds (41%). Less than 10% of the holdings are investment grade. The fund utilizes 33% leverage and has an expense ratio of 1.2%. The distribution is 12.5%, funded by income with no return of capital (NYSE: ROC ). AGIC Convertible and Income II (NYSE: NCZ ). This is a sister fund to NCV and over the past 5 years, the prices of these two funds have been 90% correlated. So if you invest in one of these funds, you gain virtually no diversification from investing in the other. Over the past 5 years, this CEF has sold mostly at a premium, sometimes as high as 17%. It was not until the second half of 2015 that the fund began selling at a discount. The five year average has been a premium of 10.4% and the 1 year average was a premium of 9.4%. The fund currently sells for a discount 9.4% and has a Z-score of negative 2.4. The portfolio consists of a combination of convertible bonds (57%) and high yield bonds (42%). Less than 10% of the holdings are investment grade. The fund utilizes 33% leverage and has an expense ratio of 1.2%. The distribution is 12.4%, funded by income with no ROC. Calamos Convertible and High Yield (NASDAQ: CHY ). Over the past 5 years this CEF has sold for a both a discount and a premium. The premium was as high as 5% in early 2015 but by late 2015 the fund sold at a discount. The 5 year average discount has been 2.9% but over the past year, the fund averaged a slight premium of 0.3%. The current discount is 8.6%. The portfolio consists of a combination of convertible bonds (55%) and high yield bonds (40%). Less than 15% of the holdings are investment grade. The fund utilizes 29% leverage and has an expense ratio of 1.5%. The distribution is 10.6%, funded by income with only a small amount of ROC. The UNII is negative and quite large when compared with the distribution, which may be a concern for maintaining future distributions. Calamos Convertible Opportunities and Income (NASDAQ: CHI ). Over the past 5 years this CEF has sold for a both a discount and a premium, alternating frequently between discount and premium. The premium was as high as 4% in 2011 but by late 2015 the fund sold at a large discount approaching 14%. The 5 year average discount has been less than 1% and over the past year, the fund’s average a discount has been 1.8%. The fund is currently selling at an 11% discount and has a Z-score of negative 2.05. The portfolio consists of a combination of convertible bonds (56%) and high yield bonds (39%). Less than 15% of the holdings are investment grade. The fund utilizes 28% leverage and has an expense ratio of 1.5%. The distribution is 10.9%, funded by income with only a very small amount of ROC. The UNII is negative and quite large when compared with the distribution, which is red flag for future distributions. This is a sister fund to CHY but over the past 5 years these two funds have only been 80% correlated so you receive a small amount diversification if you own both of these CEFs. Advent Claymore Convertible and Income (NYSE: AVK ). Over the past 5 years, this CEF has always sold at a discount. The five year average has been a discount over 8% and the 1 year average is an even higher discount of 10.5%. The current discount is a large 16.8%, which translates into a Z-score negative 2.78. The portfolio consists of a combination of convertible bonds (64%) and high yield bonds (31%). About 10% of the holdings are investment grade. The fund utilizes 37% leverage and has an expense ratio of 2%. The distribution is 8.1%, funded by income with a substantial (40%) ROC component. UNII is negative and large compared with the distribution. Advent Claymore Convertible Securities and Income (NYSE: AGC ). Over the past 5 years, this CEF has usually sold at a discount. The only premium was for a short time in 2010 and was less than a 5% premium. The five year average has been a discount of 8.7% and the 1 year average is an even higher discount of 13.8%. The current discount is over 17%, which translates into a Z-score of negative 1.95. The portfolio consists of a combination of convertible bonds (63%) and high yield bonds (28%). The portfolio also has a small (5%) equity component. About 10% of the holdings are investment grade. The fund utilizes 40% leverage and has an expense ratio of 3.1%. The distribution is 10.1%, funded by income with a substantial (70%) ROC component. UNII is negative and large compared with the distribution. Even though AGC is in the same family as AVK, the prices of these CEFs have been less than 60% correlated over the past 5 years. As a reference, I compared the performance of the convertible CEFs to the following exchange traded fund (ETF). SPDR Barclays Convertible Securities (NYSEARCA: CWB ) . This is the largest and most liquid convertible bond ETF. The fund was launched in 2009 and holds about 100 convertible bonds. ETFs are constructed so that they typically sell very near NAV, so there is no discount or premium. ETF has an expense ratio of 0.4% and yielded 4.5% over the past year. To assess the performance of the selected CEFs, I plotted the annualized rate of return in excess of the risk free rate (called Excess Mu in the charts) versus the volatility of each of the component funds over the past 5 years (from August, 2010 to August, 2015). The risk free rate was set at 0% so that performance could be easily assessed. This plot is shown in Figure 1. Note that the rate of return is based on price, not Net Asset Value (NAV). (click to enlarge) Figure 1: Reward versus risk over past 5 years The figure indicates that there has been a wide range of returns and volatilities associated with convertibles CEFs. For example, NCV had a high return but also a high volatility. Was the return worth the increased volatility? To answer this question, I calculated the Sharpe Ratio for each fund. The Sharpe Ratio is a metric, developed by Nobel laureate William Sharpe that measures risk-adjusted performance. It is calculated as the ratio of the excess return over the volatility. This reward-to-risk ratio (assuming that risk is measured by volatility) is a good way to compare peers to assess if higher returns are due to superior investment performance or from taking additional risk. On the figure, I also plotted a red line that represents the Sharpe Ratio of NCV. If an asset is above the line, it has a higher Sharpe Ratio than NCV, which means it has a higher risk-adjusted return. Conversely, if an asset is below the line, the reward-to-risk is worse than NCV. Some interesting observations are apparent from the plot. With the exception of AGC, the convertible CEFs had a respectable return over the past 5 years even though they recently sold off. Since CWB did not sell at a premium or a discount, it is not surprising that it had the best risk-adjusted performance over the period of the analysis. Looking at only CEFs, CHY, CHI, and NCV had nearly the same risk-adjusted performance. NCZ was close behind. AGC was the worst performer and only barely stayed in positive territory. The volatility of convertible CEFs ranged from about 15% to 17% (this is similar to the volatility of the S&P 500 over the same period) The 5 year look-back data shows how these funds have performed in the past. However, the real question is how they will perform in the future when the bull market in convertibles returns. Of course, no one knows, but we can obtain some insight by looking at the most recent bull market period from June, 2012 to September, 2014. Figure 2 plots the risk versus reward for the funds over this bull market time frame. As expected, all the funds did well. The performance of the CEFs were tightly bunched but NCZ was the clear leader among the CEFs. Somewhat surprisingly, CWB still turned in the best risk-adjusted performance. However, NCZ had the best return on an absolute basis. (click to enlarge) Figure 2 Risk versus reward over a convertible bull market Bottom Line Convertible bond CEFs have taken it on the chin lately and the discounts have widened to historic proportions. Is it time to buy these CEFs? To my mind, the answer is yes, especially NCZ. NCZ is currently selling at a discount, which is rare. If the discount reverts back to the mean, you will receive a capital gain along with collecting 12% in distributions. Not a bad combination! Of course, the discount could widen and it may time a long time for this CEF to recover, but I am willing to wait. CHY has had exceptional performance in the past and is also selling at steep discounts. This would be another alternative but I am a little worried about the large UNII and ROC. If you are risk adverse, you may want to consider CWB. There is no doubt this is the best in terms of risk-adjusted performance. However, you will not receive any “reversion to the mean” benefits. I normally choose asset with the best risk-adjusted returns but in this case, I am willing to take a slight gamble and go with NCZ. This is a special situation where I think I can capitalize on the selloff in CEFs and hope for that the large discount associated with this CEF will revert back to the mean.

Guide To Inverse And Leveraged Biotech ETF Investing

Biotech investing has been on a see-saw ride of pains and gains this year. This piping hot corner of the broad U.S. health care market can easily be termed as one of the super performers in the last five years and can be an intriguing bet for investors with a long-term view. The biggest biotech ETF, the iShares Nasdaq Biotechnology ETF (NASDAQ: IBB ), gained over 285% during this frame. Last year too, this high-growth sector delivered a stellar 34% return and outdid all the other sectors. The Fed’s super-easy monetary policy, a whirlwind of mergers and acquisitions, promising industry fundamentals, plenty of drug launches, FDA approvals for the highlyawaited drugs, ever-increasing demand in emerging markets, surging health care spending and Obama care wrote the success story at biotech. However, the space has long been guilty of overvaluation; with even the Fed chair Yellen pointing to it last year. As a result, the space succumbs to a correction just as the broader market hits any growth-related bump and a risk-off trade sentiment takes over. This well explains why the biotech space has been floundering in the recent global market rout instigated by a Chinese market crash. If this was not enough, Hillary Clinton, who is a presidential candidate, recently raised concerns about the over pricing on life-saving drugs on Twitter. This tweet came on the heels of a 5,455% price hike (in about two months) of a drug called Daraprim, used to treat malaria and toxoplasmosis. This apparently eccentric pricing action was taken by a privately held biotech company Turing Pharmaceuticals. On the whole, branded drug prices underwent a rise of about 14.8% last year, as per research firm Truveris. There are several other drugs namely cycloserine, Isuprel, Nitropress, and doxycycline that have seen enormous price hikes this year, per the source. As a result, the drumbeat of losses for biotech stocks resumed in full volume on apprehensions of stringent government regulation on pricing matters. What’s in Store? No wonder, sectors as important and sensitive as biotech and pharmaceutical should be in talks prior to the election season. Barrons.com notified that biotech and pharma stocks underperformed the broader market during the last four election cycles when comparing figures 3 months before to the primaries and 3 months after the elections (read: The Comprehensive Guide to Biotech ETFs ). Barrons’ analysis shows that the broader market indices including S&P 500, Dow Jones, and NASDAQ composite gained 11%, 8%, and 18%, respectively, on average against 15% and 1% loss incurred by the NASDAQ Biotech index and NYSE Arca Pharmaceutical Index, respectively during last four election phases. Thus, like several analysts we too believe that the biotech space will likely remain flippant. However, the space should soar once these doubts clear up given the strong fundamentals and a compelling valuation especially after the recent sell-off. Till everything settles, investors might intend to choose products with short-term notion. And what could be better options than inverse and leverage biotech ETFs to accomplish this notion? Due to their compounding effect, investors can enjoy higher returns for a very short period of time. Holding the product for long could lead to extreme losses. Below, we have highlighted three ETFs in each case – both for bear and bull markets – that could deliver astounding gains, depending on the biotech market trend, easily crushing the broader market. Bear Biotech ETFs – Inverse Leveraged These products would be apt for the present beaten-down market environment. ProShares UltraPro Short NASDAQ Biotechnology ETF (NASDAQ: ZBIO ) Leveraged Factor: (-)3x Benchmark Index : NASDAQ Biotechnology Index The index is a modified capitalization weighted and includes biotech or pharma securities listed on the NASDAQ. The ETF has amassed about $7.7 million in its asset base while charges 95 bps in fees per year from investors. The fund trades over 50,000 shares a day on average and added 29% in the last three months (as of September 24, 2015). Direxion Daily S&P Biotech Bear 3x Shares (NYSEARCA: LABD ) Leveraged Factor: (-)3x Benchmark Index : S&P Biotechnology Select Industry Index The fund has amassed about $18.7 million so far and trades in volumes of about 275,000 shares a day. This product also charges 95 bps in fees and added 19.5% in the last three months. ProShares UltraShort Nasdaq Biotechnology ETF (NASDAQ: BIS ) Leveraged Factor: (-)2x Benchmark Index : NASDAQ Biotechnology Index This $171.6-million ETF trades in volumes of about 750,000 shares a day and charges 95 bps in fees. The fund surged over 21% in the last three months. Bull Biotech ETFs – Leveraged These products would suit investors on a biotech market recovery. ProShares UltraPro NASDAQ Biotechnology ETF (NASDAQ: UBIO ) Leveraged Factor: 3x Benchmark Index : NASDAQ Biotechnology Index This $37-million ETF trades in volumes of about 275,000 shares a day and charges 95 bps in fees. The fund lost over 39% in the last three months. Direxion Daily S&P Biotech Bull 3x Shares ETF (NYSEARCA: LABU ) Leveraged Factor: 3x Benchmark Index : S&P Biotechnology Select Industry This $112-million ETF trades in volumes of about 600,000 shares a day and charges 95 bps in fees. The fund shed over 42% in the last three months. ProShares Ultra Nasdaq Biotechnology ETF (NASDAQ: BIB ) Leveraged Factor: 2x Benchmark Index : NASDAQ Biotechnology Index This $786.1-million ETF trades in volumes of about one million shares a day and charges 95 bps in fees. The fund was down about 27% in the last three months. Link to the original link on Zack.com

How I’ll Use What I Learned From My Premature Buy Of SVXY

Summary August 25 — a special day. On Seeking Alpha I urged being long SVXY and CBOE first publicly exposed its 9-day time horizon Volatility Index, accompanying the 30-day index. Market-makers and prop traders use VIX-based securities in their hedging. The longer the time to expiration of the contracts involved, the larger the uncertainty, the higher the cost. CBOE insiders had watched VXST, the new index, behavior privately for months before its release. Its shorter time horizon can advantage arbitrages and reduce capital haircuts. It’s embrace by other investment professionals and by the public was anticipated, but not certain. It turned out to have a dramatic effect on the established, longer-time index. On October 8th trading will begin in options on the VXST, further elaborating the shorter-term VIX-index securities inter-relationships web. Then we will have better expectations information. Meanwhile, tail wagging the dog? The CBOE has had since August 25 to see how options on the VXST should behave. No doubt they are conducting internal training sessions to encourage rational member trading activities. I have to believe they also learned from market reactions since August 25. Figure 1 shows how hedger expectations for the longer-term VIX index changed at that point. Figure 1 (used with permission) The VIX index is, excuse the expression, volatile. The forecast ranges for the index in Figure 1 are derived in the same way as our market-maker forecast reports on stocks and ETFs. The only difference is that the hedging in index derivatives is done in markets not easily accessible by individual investors, at a scale not inviting to personal portfolios. It should be evident that prior to late August this year the 30-day volatility index had a fairly reliable bottom around 12, with upper expectations reaching into the area of 20. Oscillations in that range provided upside excursions of as much as 75% {(20-12) / 12} and might occur in a week or two. Playing that game adroitly (flawlessly) for a year or two could earn a comfortable retirement for generations of the family. But since August 25, there’s a new sheriff in Dodge. Whether he has brought more or less law to town is not yet evident. Madam CBOE’s establishment appears to have taken on a new vibrancy in the company of VXST. What it has meant for the ProShares Short VIX Short-Term Futures ETF (NYSEARCA: SVXY ) is alluded to in Figure 2. Figure 2 (click to enlarge) My guess is that there’ll be lots of moderately-restrained fun and adventure in town until the court comes to session, starting on October 8th. Then we’ll see what his honor Mr. Market has to say in judgment. Conclusion Stay tuned for intra-day thrills and spills while those with short-time horizons have their fun, adventures, greed and fear. Meanwhile, those with longer visions (out to the next calendar quarter at least) think there’s already lots more upside than downside among portfolio investment candidates. Check out yesterday’s market profile in Figure 3. Figure 3 (provided with permission) Pictured here are over 2500 stocks and ETFs’ price range forecast balances between upside and downside prospects. Normally the distribution would be centered around a Range Index of 40 instead of 21 (40% of the range to the downside, 60% up) with no or few screaming bargains on the left. Market outlook implication: fear has taken over, but may be fatiguing for lack of downside opportunity. If so, SVXY could again be attractive – but we’ll wait for October to decide. Share this article with a colleague