CSQ CEF: Earn An Income At A Discount

There can be little doubt that one of the biggest problems facing the average American is the incredibly high inflation that has been dominating the economy for a considerable amount of time. Indeed, over the past twelve months, the consumer price index has posted at least a 6% year-over-year increase:

This has caused real wage growth to be negative for the past two years and since much of the inflation pressure has been on food and energy, which are necessities, it has proven to be a particularly challenging situation for people on tight budgets or limited incomes. I discussed some of the pressure facing the average person in a recent blog post.

As might be expected, people have responded to the pressure on their household budgets in a variety of ways, but many have attempted to get second jobs or enter into the gig economy. Others have drawn down their savings or run up revolving credit card balances to make ends meet.

As investors, we are certainly not immune to this. After all, we need food and energy for survival and comfort just like anyone else. We do, however, have different methods that we can employ to obtain the extra income that we require to maintain our lifestyles in the current conditions. Most notably, we can put our money to work for us earning an income. One of the best ways to do this is to purchase shares of a closed-end fund, or CEF, that specializes in the generation of income.

These CEF funds are unfortunately not very well followed in the financial media and many financial advisors and professionals are not familiar with them. As such, it can be difficult to obtain the information that we would really like to have to make an informed investment decision. This is a shame because these funds offer a number of advantages over more familiar open-ended or exchange-traded funds. In particular, they are able to use a number of strategies that can boost their yields well beyond that of anything else in the market.

In this article, we will discuss the Calamos Strategic Total Return Fund (NASDAQ:CSQ), which currently boasts an impressive 9.26% yield. That is certainly enough to appeal to any income-seeking investor and easily high enough to provide a much-needed income boost with money left over for reinvestment. This is exactly the kind of situation that we like to have. Let us investigate and see if this fund could be a good addition to a portfolio today.

About The Fund

According to the fund’s webpage, the Calamos Strategic Total Return Fund has the objective of providing its investors with a high level of total return. This is hardly surprising, considering the fund’s name. As is the case with most closed-end funds, though, it aims to maintain a somewhat static portfolio size and pay out all of its returns to its investors. This is where the fund’s high yield comes from.

We would normally expect a fund focusing on total return to favor investment in common equities. After all, common equities are generally the instruments that investors seeking high returns purchase due to the fact that they provide income through the dividends that they pay out as well as benefit from capital appreciation as the issuing company grows and prospers. This fund is a bit different, however, as it invests in both common equity and fixed-income securities. According to the fund’s webpage,

The fund seeks total return through a combination of capital appreciation and current income by investing in a diversified portfolio of equities, convertible securities, and high-yield bonds.

The portfolio currently reflects this, although it is more highly weighted to common stock than fixed-income:

This is not especially surprising considering that common stock generally offers higher total return potential than bonds. This is still true even though the yield on most bonds has improved substantially over the past year. In fact, interest rates are currently at the highest levels that we have seen since 2007:

As bond yields and interest rates are linked, bonds will generally have the highest income potential that they have had for a long time. They also have upside potential if and when the Federal Reserve cuts rates. That is because bond prices go up when interest rates go down. Thus, bonds are probably a better investment today than they have been in more than a decade as most analysts are projecting that the Federal Reserve will stop its monetary tightening cycle after one or two more rate hikes extending out until July. Meanwhile, the economy is showing signs of economic weakness that would ordinarily be bad for stocks as recessions tend to have a negative impact on corporate earnings.

The reason that the market has been trending upward lately is that the market believes that a recession will prompt the Federal Reserve to cut rates. If the current very hawkish tone of the Federal Reserve is any indication, that will not happen and we will be in for a stock market decline in the second half of the year. That will undoubtedly punish the fund for its current bullish stance.

With that said, stocks do significantly outperform bonds over the long-term and that might be what this fund’s management team is anticipating will continue to be the case. I cannot see any reason why it would not be since there is a limit to how high interest rates can go until the debt service payments on the U.S. national debt become impossible to carry with tax revenue. For the near term, the fund might be better off being overweight bonds before rotating back into stocks around the end of the year, but that would be market timing as well as contrarian and such tactics tend to be pretty difficult to pull off with success consistently.

As I mentioned in a recent report, the overwhelming majority of the total returns delivered by the S&P 500 Index (SP500) this year have been due to a handful of large technology stocks. There thus should not be any real surprise that the fund’s largest positions are dominated by huge technology companies:

We can see several of the largest technology companies in the world here, including Apple Inc. (AAPL), Microsoft Corporation (MSFT), Alphabet Inc. (GOOGL) aka Google, and Amazon.com, Inc. (AMZN). We also see Nvidia Corporation (NVDA), which has delivered outsized performance this year due to the emerging AI boom that could very easily turn into the next bubble. Curiously, these stocks generally underperformed the market by quite a lot last year so many people consider them value plays despite the fact that several of them are currently trading at among their highest price-to-free cash flow ratios in history:

The future is naturally hard to predict, but it would be logical to assume that these stocks will reverse should the consensus about an interest rate cut in the second half of the year prove to be wrong. That would naturally have a negative impact on this fund given its high allocation to four of these five stocks. Fortunately, the remainder of the fund’s largest positions is fairly well diversified between healthcare, energy, telecommunications, and Visa Inc. (V), but the 16.5% exposure to five technology companies is a risk that investors should not ignore. Fortunately, though, this fund is not as heavily exposed to these huge technology companies as some of Eaton Vance’s equity closed-end funds.

A look at the largest positions in the fund will almost inevitably lead someone to believe that the fund is strictly American. After all, everything on the list is an American company. However, this is not strictly the case, but most of the fund’s assets are indeed invested domestically:

The United States only accounts for a bit less than a quarter of the total global domestic product. Thus, this fund is significantly overvalued to the United States relative to its actual representation in the global economy. This is not strictly speaking a problem though since this fund also does not market itself as a global fund. It is still important to keep in mind that you have sufficient global exposure from other assets in your portfolio to protect against regime risk, which is the risk that a government will take an action that has an adverse impact on a company in your portfolio. The only real way to protect yourself against this risk is to ensure that only a small proportion of your assets is invested in any individual nation. That can easily be achieved by investing in an international fund that specifically excludes the United States alongside this one.

Leverage

As mentioned in the introduction, closed-end funds like the Calamos Strategic Total Return Fund have the ability to employ certain strategies that allow them to boost their returns well beyond that of any of the underlying assets as well as produce a higher yield than just about anything else in the market. One of these strategies is the use of leverage. In short, the fund is borrowing money and using that borrowed money to purchase stocks and bonds. As long as the purchased assets produce a higher return than the interest rate that the fund has to pay on the borrowed money, the strategy works pretty well to boost the effective return of the portfolio. As this fund is capable of borrowing money at institutional rates, which are considerably lower than retail rates, this will usually be the case.

However, the use of debt in this fashion is a double-edged sword. This is because leverage boosts both gains and losses. As such, we want to ensure that the fund is not employing too much leverage because that would expose us to an excessive level of risk. I typically like to see a fund’s leverage under a third as a percentage of its assets for this reason. The Calamos Strategic Total Return Fund’s levered assets currently comprise 33.89% of its portfolio so it is right about at that level. As such, the fund appears to be running a reasonable balance between risk and reward. It is important to note that it will decline more than the market in the likely event of a near-term correction, though.

Distribution Analysis

One of the most attractive features of closed-end funds is that they tend to pay out all of their income and capital gains to their investors in the form of distributions. The basic objective is for the portfolio to maintain a relatively stable level per share, with all returns being paid out over time. In order to generate returns, the Calamos Strategic Total Return Fund assembles a portfolio of common stocks and fixed-income securities and then applies a layer of leverage to boost the return. It then pays out its returns to the investors. As such, we can probably assume that the fund will boast a fairly high yield if it is successful at earning returns. This is indeed the case as the fund pays a monthly distribution of $0.1025 per share ($1.23 per share annually), which gives it a 9.26% yield at the current price. The fund has been remarkably consistent about its distribution over the years, as it has generally been growing since the Great Recession:

This is one of the best track records of any closed-end fund, as most have had a somewhat more variable distribution over the past decade. We have even seen many that have been forced to cut their payouts in response to the challenging market conditions last year. As this one has clearly performed much better than its peers in this respect, it is a good idea to investigate its finances in order to determine how sustainable the distribution is. After all, we do not want the fund to suddenly have to cut the distribution since that would reduce our incomes and almost certainly cause the share price to decline.

Unfortunately, we do not have a particularly recent document that we can consult for the purposes of our analysis. As of the time of writing, the fund’s most recent financial report corresponds to the full-year period that ended on October 31, 2023. As such, it will not provide any information about how well the fund performed over the past seven months. This is unfortunate because the market has exhibited some volatility over that period including panics over several bank collapses and the debt ceiling. This report will still give us some insight into how well the fund handled the early stages of the Federal Reserve’s monetary tightening regime though, which was by far the most challenging for it. During the full-year period, the Calamos Strategic Total Return Fund received $44,894,476 in dividends and $34,249,795 in interest from the assets in its portfolio. However, some of this interest was actually the payment of principal, so it is not considered income.

The fund actually reported a total investment income of $71,134,313 over the period. It paid its expenses out of this amount, which left it with $7,926,485 available for investors. That was obviously nowhere close to enough to cover the $194,318,141 that the fund paid out in distributions during the period. This is concerning at first glance because the fund’s net investment income is nowhere close to enough to cover the distributions.

Fortunately, Calamos Strategic Total Return Fund does have other means through which it can obtain the money that it needs to cover its distributions. For example, it might have substantial capital gains that could be paid out. Perhaps surprisingly given the challenging market conditions of 2022, the fund enjoyed a great deal of success at this task. It managed to achieve net realized gains of $159,464,046 during the period, although this was more than offset by $770,361,601 net unrealized losses.

Overall, the fund’s assets declined by a whopping $771,805,644 after accounting for all inflows and outflows. With that said, the net realized gains and net investment income did manage to cover most of the distributions that were paid out. These two items together totaled $167,390,531, which was sufficient to cover 86.14% of the distributions that were paid out. In addition to this, the fund’s assets were actually higher on October 31, 2022, than they were on November 1, 2020, despite the fund paying out distributions for the entirety of both years.

Thus, it did manage to cover its distribution over the two-year period. This is a good sign that should bode well going forward unless we end up with a multi-year period of sustained weakness in both the stock and bond markets. That is a possibility, but I somewhat doubt it will be the case. The fund should probably be fine to maintain the distribution.

Valuation

It is always critical that we do not overpay for any assets in our portfolios. This is because overpaying for any asset is a surefire way to earn a suboptimal return on that asset. In the case of a closed-end fund like the Calamos Strategic Total Return Fund, the usual way to value it is by looking at the fund’s net asset value. The net asset value of a fund is the total current market value of all the fund’s assets minus any outstanding debt. It is therefore the amount that the shareholders would receive if the fund were immediately shut down and liquidated.

Ideally, we want to purchase shares of a fund when we can obtain them at a price that is less than the net asset value. This is because such a scenario implies that we are buying the fund’s assets for less than they are actually worth. That is fortunately the case with this fund today. As of May 24, 2023 (the most recent date for which data is available as of the time of writing), the Calamos Strategic Total Return Fund had a net asset value of $13.78 per share but the shares trade for $13.42 today. That works out to a 2.61% discount on the net asset value. This is in line with the 2.41% discount that the shares have had on average over the past month, so the price certainly looks to be reasonable.

Conclusion

In conclusion, the Calamos Strategic Total Return Fund looks to be a pretty good way to earn a high yield today. The fund is heavily weighted to a handful of large technology companies that may be at risk of decline if the Federal Reserve stands by its hawkish statements, but it is not as bad as many other equity funds in this respect. The fund has an acceptable level of leverage and the 9.26% yield surprisingly appears to be sustainable. When this is combined with the fund’s current discount, Calamos Strategic Total Return Fund might be worth picking up today if you are comfortable with the risks of those technology companies.