NCZ: Good Concept, But This Convertible Fund Does Not Measure Up

The Virtus Convertible & Income Fund II (NYSE:NCZ) is a closed-end fund that invests in a combination of convertible bonds, common stock, and fixed-income securities. This is a good concept, although it is perhaps not quite as attractive as it was a few years ago. For most of the past fifteen years, it was very difficult to obtain an income from either common stocks or fixed-income securities, so convertibles were a nice compromise. They allowed investors to get at least some income today without requiring them to sacrifice the upside potential that was only possible through investment in common stocks. However, now that interest rates have once again risen to a reasonable level, fixed-income securities are actually attractive to hold by themselves. The bubble that existed in convertibles back in 2020 and 2021 has popped and leveraged closed-end funds such as the Virtus Convertible & Income Fund II continue to pay the price even today.

This is not to say that there is nothing at all attractive about this fund today. It does have a 12.59% yield at the current price, which is quite attractive relative to common stocks, junk bonds, or just about any other asset type. The fund’s yield also compares reasonably well to that of its peers, as we can see here:

Fund Name	Morningstar Classification	Current Yield
Virtus Convertible & Income Fund II	Fixed Income-Taxable-Convertibles	12.59%
Advent Convertible and Income Fund (AVK)	Fixed Income-Taxable-Convertibles	11.77%
Bancroft Fund (BCV)	Fixed Income-Taxable-Convertibles	8.29%
Calamos Convertible Opportunities and Income Fund (CHI)	Fixed Income-Taxable-Convertibles	10.30%
Ellsworth Growth and Income Fund (ECF)	Fixed Income-Taxable-Convertibles	6.54%
High Income Securities Fund (PCF)	Fixed Income-Taxable-Convertibles	11.48%

Click to enlarge

We can certainly see a number of double-digit yields, which is a rarity today as most closed-end funds only have a high single-digit yield unless they are investing in leveraged loans. The Virtus Convertible & Income Fund II does manage to beat out its peers in terms of yield, despite this prevalence of extremely high yields. This is something that may appeal to those investors who are seeking to earn a very high current income from the assets in their portfolios. However, yield alone is not everything so we should certainly investigate further.

As regular readers can likely remember, we previously discussed the Virtus Convertible & Income Fund II in the middle of December 2023. The market at that time was very different than the one that we have today. During the final two months of 2023, many market participants were expecting that the Federal Reserve would rapidly reduce interest rates (pricing in as many as 150 to 175 basis points of cuts) and were aggressively buying up just above everything in the market in an attempt to front-run the central bank. However, since the start of this year, the prospect of interest rate reductions has looked less and less likely. Therefore, the bond market has been selling off over the past several months. The stock market has remained strong though, and convertible bonds frequently trade with some degree of correlation to stock prices. As such, we can probably expect the fund’s shares to have delivered mixed performance since our previous discussion. Curiously, this has not been the case as shares of the Virtus Convertible & Income Fund II are down 4.03% since the date of the prior article’s publication. This is worse than the 2.75% loss incurred by the Bloomberg U.S. Aggregate Bond Index. It is much worse than the gains that we have seen in both the S&P 500 Index (SP500) and the iShares Convertible Bond ETF (ICVT) over the same period:

When we consider that this fund’s reputation took a substantial hit following the market rout in 2022, we should probably not be too surprised that it is underperforming the indices. This is still a very substantial underperformance though, and it almost certainly reduces the fund’s appeal in the minds of those investors who are somewhat risk-averse.

However, as I have pointed out numerous times in the past, the share price performance of a closed-end fund does not tell the whole story. In fact, investors in these funds tend to do much better than the share price movements would suggest. This is because closed-end funds tend to pay out most or all of their investment profits to the shareholders in the form of distributions. The basic business model is to try and keep the portfolio’s size relatively stable over time while giving the investors all of the profits. This is the reason why closed-end funds tend to have some of the highest yields available in the marketplace. The distributions also provide a real return on investment that is in addition to the share price movement. As a result, investors who hold a fund for any length of time will receive a higher total return than the share price performance suggests. As such, we should include the fund’s distributions in any discussion of its performance. When we do this, we see that investors in the Virtus Convertible & Income Fund II have basically broken even since the date that the prior article was published. This is actually better than investment-grade bonds returned over the same period:

We do still see that the fund underperformed the convertible bond index and common stocks over the period. Unfortunately, the fund’s history of underperformance does not end there as it has underperformed all three indices over the past three-, five-, and ten-year periods. This is true even when we consider that this fund consistently has a much higher yield than any of the other three asset classes. This would appear to suggest that there is no reason to purchase this fund as opposed to any of the three exchange-traded funds shown above. In fact, investors in any of those index funds over most extended periods would have been better off.

However, the disappointing past performance of a fund is no guarantee that it will not improve in the future. As such, it is still a good idea for us to take a closer look at it and see if it could make any sense to purchase it today as a way of achieving our goals.

About The Fund

According to the fund’s website, the Virtus Convertible & Income Fund II has the primary objective of providing its investors with a very high level of total return. This makes a lot of sense given the fund’s strategy, which the website explains in great detail:

The Fund seeks total return through a combination of capital appreciation and high current income.

[The Fund] invests in a portfolio of domestic convertible securities and high-yield bonds rated below investment grade.

Under normal circumstances, the Fund will invest at least 80% of its total assets in a diversified portfolio of convertible securities and non-convertible income-producing securities and also seeks to invest at least 50% of its total assets in convertible securities, but determines its allocation based on changes in equity prices, changes in interest rates, and other economic and market factors. For the convertible portion, Voya Investment Management seeks to capture the upside potential of equities with potentially less volatility than a pure stock investment.

This quotation specifically states that the fund will invest at least half of its assets in convertible securities, with an additional 0% and 30% invested in junk bonds. It was fulfilling that requirement at the start of the year, as we can see here:

For some reason, the most recent asset allocation on the webpage (screenshotted) is older than the fund’s annual report. The annual report gives the fund’s asset allocation as follows:

Asset Type	% Weighting
Convertible Bonds and Notes	89.4%
Corporate Bonds and Notes	63.5%
Convertible Preferred Stock	6.4%
Non-Convertible Preferred Stock	0.2%
Common Stock	0.0%
Total Warrants	0.0%
Money Market Fund	0.0%
Securities Lending Collateral	3.5%

Click to enlarge

Please note that everything shown above with a 0.0% weighting does have a very small asset allocation that rounds to 0.0%. For example, the fund actually had $22,668 invested in common stocks as of January 31, 2024. However, that is such a small percentage of the portfolio that it is for all purposes that matter irrelevant.

As I have explained in numerous previous articles, corporate bonds deliver most or all of their investment return in the form of direct payments to their owners. In this case, that owner would be the fund. As such, they are primarily income vehicles. However, convertible bonds are total return instruments much like common stocks. Convertible bonds do deliver much of their investment returns in the form of coupon payments just like corporate bonds. However, the convertibility feature is what makes them total return vehicles because their capital gains are potentially unlimited. After all, common stocks can theoretically appreciate to infinity and as such the bond itself has potentially unlimited upside following the conversion to common stock. Thus, a total return objective makes a great deal of sense for this fund.

In my last article on this fund, I pointed out that convertible securities are frequently issued by companies that have limited revenue and cash flow or are otherwise struggling in some way. Specifically, I stated:

In general, convertible debt is issued by companies that have strained cash flow, high levels of already existing debt, or some other problem that makes it very difficult for them to obtain financing at a reasonable cost. For example, a start-up company with limited revenue might choose to issue these securities. The ability to convert the debt into common stock may induce investors to accept a lower interest rate in the hopes that they can turn a huge capital gains profit when the start-up company becomes successful, or the company fixes whatever problem was causing it to struggle with obtaining affordable financing.

A look at the largest positions in the fund does indeed reveal a number of companies that are either very young with limited cash flow or companies that were in a precarious financial situation at some time in the recent past. Here are the largest positions in the fund today:

A reader may immediately question how I could say that many of these companies are young or struggling. However, it makes more sense when we consider when some of these companies were started:

Founding	Start-Up Date
Wells Fargo & Company (WFC)	1929
Palo Alto Networks (PANW)	2005
Welltower (WELL)	1970
Southern Company (SO)	1945
Block Inc. (SQ)	2009
CCF Holdings (OTC:CCFLU)	2018
Affirm Holdings (AFRM)	2012
Akamai Technologies (AKAM)	1998
Royal Caribbean Cruises (RCL)	1968
Seagate HDD Cayman (STX)	1979

Click to enlarge

We can see several companies on this list that are less than twenty years old. They may be reasonably successful companies today, but because bonds can be issued with somewhat lengthy terms it is quite easy to see that many of these convertible securities could have been issued years ago when the company was less successful than it is today. We do see a few older companies on this list though, such as Wells Fargo and Royal Caribbean. The Wells Fargo securities held by this fund are the Series L convertible preferreds, which were issued in early 2008. As anyone who can remember that period of time will be well aware, it is not a stretch to say that the banking sector in general was not having an easy time obtaining affordable financing. Royal Caribbean, meanwhile, encountered problems getting financing both during the 2009 recession and the 2020 COVID-19 pandemic. We can therefore very quickly see that the basic goal of many convertible issues is to obtain financing for an affordable price and promise the investors the potential for capital gains in the future in exchange for accepting a lower interest rate today. In the case of the offerings that compromise the largest positions in this fund, the investors have generally made out pretty well.

There have been a few changes to the fund’s largest positions since the last time that we discussed it. In particular, Liberty Broadband (LBRDK), Uber Technologies (UBER), Zillow Group (Z), and ON Semiconductor (ON) have all been removed from their former positions among the fund’s largest issuers. In their place, we have Block, Affirm Holdings, Royal Caribbean, and Seagate. This is quite a few changes for only a four-month period, which could suggest that the fund has a fairly high turnover. Indeed, the annual report puts its turnover at 108.00% for the full-year period ending on January 31, 2024, so the fund is definitely engaging in a great deal of asset swapping and trading. Indeed, this fund seems to engage in more trading activity than some of its peers:

Fund Name	Annual Turnover
Virtus Convertible & Income Fund II	108.00%
Advent Convertible & Income Fund	116.00%
Bancroft Fund	44.00%
Calamos Convertible Opportunities and Income Fund	39.00%
Ellsworth Growth and Income Fund	47.00%
High Income Securities Fund	52.00%

Click to enlarge

(all figures are from the most recent annual reports for each respective fund)

As we can clearly see, the Virtus Convertible & Income Fund II has a higher turnover than any of its peers except for the Advent Convertible & Income Fund. This is important because it costs money to trade stocks or other assets, and these expenses are billed directly to the fund’s investors. That creates a drag on the fund’s performance since investors only receive the fund’s total return after it pays its expenses. Therefore, all else being equal, the higher a fund’s expenses, the lower its total return.

Speaking of expenses, the Virtus Convertible and Income Fund II had an expense ratio of 2.74% for the full-year period that ended on January 31, 2024. For some reason, CEF Data puts this fund’s expense ratio at 4.94%. While that third-party source is frequently correct, I am not sure where that figure comes from as the annual report says 2.74%. Here is how this fund compares with its peers:

Fund Name	Expense Ratio
Virtus Convertible & Income Fund II	2.74%
Advent Convertible & Income Fund	5.73%
Bancroft Fund	1.59%
Calamos Convertible Opportunities and Income Fund	4.40%
Ellsworth Growth and Income Fund	1.41%
High Income Securities Fund	0.95%

Click to enlarge

The fund’s 2.74% expense ratio will certainly seem very high to those investors who are very used to the sub-1% ratios possessed by most unleveraged index funds. However, as we can easily see, the fund’s expenses are actually pretty reasonable when compared to its peers.

A look at the comments section of many articles on closed-end or exchange-traded funds here at Seeking Alpha reveals that many investors do not like high fees. However, as I pointed out in a recent article:

Ultimately, we should not look solely at a fund’s expense ratio. After all, if its performance is good enough to cover the expense ratio and still provide an attractive overall return, then it is generally worth paying the higher expenses.

In this case though, it is highly questionable whether or not it is really worth paying this fund’s expenses. This chart shows the total return of all six of the funds being used for our peer comparison over the past three years:

The Virtus Convertible & Income Fund II is certainly not the worst performer in this grouping. In fact, the 20.35% loss suffered by its investors is relatively middle of the road as two funds did worse and three did better. Interestingly, two of the three that did better have much higher expense ratios. As the returns realized by investors are after expenses, this suggests that the fund’s expense ratio alone is not necessarily the problem. With that said though, the iShares Convertible Bond ETF had a -12.50% total return over the period, so it still beat this fund and was the median performer.

Leverage

As is the case with most closed-end funds, the Virtus Convertible & Income Fund II employs leverage as a method of boosting its effective total return and the yield that it earns from the assets in its portfolio. I explained how this works in my prior article on this fund:

Basically, the fund borrows money and then uses that borrowed money to purchase convertible securities, junk bonds, and similar income-producing assets. As long as the total return that the fund receives from the purchased assets is higher than the interest rate that it needs to pay on the borrowed money, the strategy works pretty well to boost the effective yield of the portfolio. This fund is capable of borrowing money at institutional rates, which are considerably lower than retail rates. As such, this will normally 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 amount of risk. I generally do not like a fund’s leverage to exceed a third as a percentage of its assets for that reason.

As of the time of writing, the Virtus Convertible and Income Fund II has leveraged assets comprising 38.54% of its portfolio. This represents an increase from the 37.64% leverage that the fund had the last time that we discussed this. This is rather concerning, as that makes this one of the only funds that I regularly discuss in this column that has actually seen its leverage increase over the past few months.

The reason for this is that the Virtus Convertible & Income Fund II is one of the few funds that has seen its net asset value decline since the previous article was published in mid-December:

It makes sense that a fund whose net asset value has declined would see its leverage increase over the same period. After all, a decline in net asset value means that the fund’s portfolio has gotten smaller over the period. Thus, if the fund kept its leverage stable, its borrowings would now represent a larger percentage of a smaller portfolio. This is exactly what has happened here.

Here is how this fund’s leverage compares to its peers:

Fund Name	Leverage Ratio
Virtus Convertible & Income Fund II	38.54%
Advent Convertible & Income Fund	41.93%
Bancroft Fund	22.00%
Calamos Convertible Opportunities and Income Fund	37.35%
Ellsworth Growth and Income Fund	24.00%
High Income Securities Fund	0.00%

Click to enlarge

(all figures from CEF Data)

As we can see here, the Virtus Convertible & Income Fund II has a higher leverage than most of its peers. It is not the most highly leveraged fund among the grouping, however. It is also not ridiculously out of line with all of the funds shown above. However, the fund is still more heavily leveraged than we really want to see, and this will make the fund a bit riskier than some of the less indebted funds shown above. As such, this is something that potential investors may want to pay attention to going forward.

Distribution Analysis

As mentioned earlier in this article, the primary objective of the Virtus Convertible & Income Fund II is to provide its investors with a very high level of total return. In pursuance of this objective, the fund invests in a portfolio of convertible fixed-income securities and junk bonds. This suggests that a substantial proportion of the fund’s total returns will come in the form of coupon payments and income. After all, this is the primary way in which both types of security deliver their investment returns. The fund pools together all of the coupon payments that it receives from the fixed-income securities in its portfolio. It even borrows money to enable it to collect payments from more securities than it can afford solely through reliance on its own equity capital. The twist here comes from the fact that some of these securities are convertible assets, so they can be converted into common stock in order to realize capital gains. The fund adds any capital gains that it realizes from this activity to the pool of money that it has already collected via coupon payments. The fund then pays all of this money out to the shareholders, net of its expenses. When we consider that yields on many fixed-income securities are currently higher than they have been in years and capital gains from successful common stocks can be quite large, we can assume that the fund’s yield will be fairly high.

This is indeed the case, as the Virtus Convertible & Income Fund II pays a monthly distribution of $0.03 per share ($0.36 per share annually). This gives the fund a 12.59% yield at the current price, which as we have already seen compares very well with other funds that employ a similar investment strategy. Unfortunately, this fund has not been especially consistent with respect to its distribution over the years. As we can see here, the trend has been distinctly negative, as this fund has steadily decreased its payout over time:

This is almost certainly going to be a turn-off for any investor who is seeking to earn a consistent and secure income from the assets in their portfolios. The fact that this fund has been steadily reducing its distributions is especially problematic considering the very high level of inflation that has been plaguing the economy. After all, the cost of everything that we purchase in our daily lives has been rapidly increasing over the past few years. As such, we need more income today to maintain a given lifestyle than we did only a few years ago. The fact that this fund’s distribution has been steadily declining has had the opposite effect.

However, as I have pointed out in the past, the fund’s history is not necessarily the most important thing for anyone who is considering purchasing shares of the fund today. This is because today’s buyer will receive the current distribution at the current yield and will not be adversely affected by anything that occurred in the past. The most important thing for today’s buyer is the fund’s ability to sustain its current distribution. Let us investigate this.

Fortunately, we have a very recent document that we can consult for the purposes of our analysis. As of the time of writing, the most recent financial report that is available for the Virtus Convertible & Income Fund II corresponds to the full-year period that ended on January 31, 2024. A link to this report was provided earlier in this article. This is a much newer financial report than the one that we had available to us the last time that we discussed this fund. In fact, this is a newer financial report than is available for most closed-end funds in the market. This is nice to see as this report will include several months of information about the fund’s performance that was unavailable to us the last time that we discussed it, including the volatile second half of 2023. As everyone reading this is likely well aware, the summer months of that year were quite challenging for most asset classes as investors began to realize that they overpriced most things during the bull run earlier in the year and so a market correction ensued. The exact opposite happened beginning in November of 2023, as numerous market participants began to buy up everything in sight in anticipation that the “free money era” would return in 2024. The first of these periods could have caused this fund to take some losses, which the second period undoubtedly allowed it the potential for some gains. This report will give us a good idea of exactly how well the fund performed.

For the full-year period that ended on January 31, 2024, the Virtus Convertible & Income Fund II received $16.257 million in interest and $1.979 million in dividends from the assets in its portfolio. When we combine this with a small amount of money from other sources, we see that the fund had a total investment income of $18.269 million over the full-year period. It paid its expenses out of this amount, which left it with $11.291 million available for shareholders. That was, unfortunately, not nearly enough to cover the $28.543 million that the fund paid out over the period. At first glance, this is likely to be quite concerning as the fund clearly did not have sufficient investment income to fully afford its distributions.

However, there are other methods through which the fund is able to obtain the money that it requires to afford its distributions. For example, it might be able to exploit price fluctuations in fixed-income securities to earn some trading profits. The fund can also realize capital gains by converting securities into common equities and selling the stock. Realized capital gains are not considered to be investment income for either tax or accounting purposes. However, they clearly do provide the fund with money that can be paid out to its shareholders.

Unfortunately, the fund generally failed to obtain money via these alternative sources over the period. For the full-year period, the fund reported net realized losses of $27.826 million but this was partially offset by $23.920 million net unrealized gains. Overall, the fund’s net assets declined by $27.153 million after accounting for all inflows and outflows during the period. This is highly concerning, as the fund clearly failed to fully cover its distributions over the course of the year.

The fund also failed to cover its distributions during the previous full-year period, which only adds to our concerns. After all, this fund has now seen its net asset value decline for two straight years. Fortunately, the fund’s net asset value has been flat so far this fiscal year:

However, there is still reason to be cautious here as the recent market weakness could put the fund in a situation where it destroys its net asset value further by distributing more than its investment profits. This fund may be in danger of a cut, all things considered.

Valuation

As of April 11, 2024 (the most recent date for which data is currently available), the Virtus Convertible & Income Fund II has a net asset value of $3.27 per share but the shares currently trade for $2.81 each. This gives the fund’s shares a 14.07% discount on net asset value. This is an incredibly large discount for any closed-end fund, and it is much more attractive than the 11.01% discount that this fund has had on average over the past month. As such, the current entry point certainly looks reasonable.

Conclusion

In conclusion, the Virtus Convertible & Income Fund II is one of the few convertible-focused closed-end funds available on the market. This gives the fund the appearance of being a reasonable way to access a fairly novel asset class. The fund’s portfolio also looks decent, as many of the companies are fairly solid and have provided attractive returns for shareholders over the years. Unfortunately, this fund just does not seem to measure up to where it probably should. It is a chronic underperformer that appears to be struggling to maintain its distribution. This could explain why the fund’s yield is higher than many peers, as the market is probably expecting a distribution cut.

Overall, the concept of buying convertible securities is a reasonable strategy for income-focused investors. This will undoubtedly become even more true should interest rates decline over the coming years. However, I just cannot recommend this fund because of its poor performance history and apparent difficulty with maintaining its distribution.