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Summary The recent sell-off in the CEF space has brought CHI to a discount value not seen since the financial crisis. 2- and 4-year z-scores in excess of negative 3.5 indicate extreme oversold conditions. CHI offers a current 10.91% yield with a possible chance of capital appreciation. With a fixed number of shares, CEFs can exhibit substantial premia or discounts to their net asset values [NAVs]. When investors become pessimistic, they become inclined to sell their CEF holdings even it if means selling at a price below the intrinsic value of the fund. Not surprisingly, the recent market turmoil has punished CEFs especially hard. As detailed in my recent article entitled ” Sell-Off In CEF Space Brings CEFL’s Discount To Record High “, 20 of the 30 constituents of the fund-of-funds CEFL (NYSEARCA: CEFL ) are at or close to 52-week high discounts. Exploiting of mean reversion in CEFs is a potential strategy to lock in higher yields as well as the chance for capital appreciation. In a July 2014 paper entitled Exploiting Closed-End Fund Discounts: The Market May Be Much More Inefficient Than You Thought , authors Patro, Piccotti and Wu provide significant evidence of mean reversion in closed-end fund premiums. This article identifies an opportunity to buy the Calamos Convertible Opportunities And Income Fund (NASDAQ: CHI ) at a greater discount than any time since the financial crisis. The fund Pertinent details for the fund are shown below. Details were obtained from Morningstar , CEFConnect or Calamos . CHI Inception 6/2002 AUM $731M Avg. volume 293K Yield (on price) 10.92% Yield (no NAV) 9.72% Adjusted yield (on price) 8.51% Adjusted yield (on NAV) 7.57% Leverage 28.34% Premium/discount -10.91% 5-year average P/D -0.30% Expense ratio 1.35% Active expense ratio 0.65% Morningstar rating **** As can be seen from the table above, CHI currently sports a 10.92% yield on price, while distributing 9.72% on its NAV. The reason for this discrepancy is due to its wide discount of -10.91%. Additionally, CHI uses 28.34% leverage. The adjusted yields shown assume 100% leverage for easier comparison to an unleveraged fund. CHI charges a total expense ratio of 1.35%. I previously devised an “active expense” metric that takes into account two factors: leverage and the expense ratio charged for a corresponding passive instrument. Taking into account the 28.34% leverage of CHI and the 0.40% expense you would to pay for the SPDR Barclays Convertible Securities ETF (NYSEARCA: CWB ), the price for the active management of CHI is a reasonable 0.65%. In terms of composition, CHI has its majority of assets in convertibles (57.06%), followed by corporate bonds (38.54%). Short-term debt and equity make up a very minor component of CHI. Widening discount Until recently, both CHI and the benchmark ETF CWB have had robust performances over the past few years. As can be seen from the graph below, CHI and CWB moved very closely from Jan. 2013 to around Mar. 2015 of this year. However, a major divergence suddenly appeared over the last few months, causing CHI to underperform by some 15% over brief period. What was the cause of CHI’s underperformance? Tracking the market price and NAV changes of the fund reveals the answer. As can be seen from the graph below, while the NAV of CHI decreased by around 10% over the past few months, mainly due to a general malaise in the high-yield credit market, the market price of CHI slumped by 20% over the same time period. The premium/discount chart of CHI over the past 1-year period shows this clearly (source: CEFConnect). Historical premium/discount Just having a wide discount alone is not good reason to buy a CEF. For mean reversion to take place, one must consider the historical premium/discount behavior of the fund. As can be seen from the chart below (source: CEFConnect), the current discount of CHI has reached levels that have not been seen since the financial crisis. Moreover, that was also the only time that the discount has exceeded -10%. In the boom years of 2002 to 2007, CHI actually experienced premia of 10%-20%, although this is unlikely to be replicated given that the ETF CWB became available from 2009 onwards. The following chart shows the current, and 1-, 3- and 5-year premium/discount values for CHI (data from CEFConnect). The z-score is a measure of the deviation of the premium/discount value of CEF from its historical value taking into account the volatility of said value. The following chart shows the 1-, 2- and 4-year z-scores for CHI (source: CEFAnalyzer). Mathematically, the 1-year z-score of -2.59 means that the discount would be expected to appear 0.48% of the time, the 2-year z-score of -3.52 corresponds to a 0.02% probability of appearance, and the 4-year z-score of -3.93 represents a measly 0.004% probability of occurrence. However, one should understand that this doesn’t mean that there’s a 99.996% chance that the discount will narrow, only that the observed discount is an extremely rare statistical occurrence. Moreover, it could be that the current discount represents a “new normal” of sorts, rendering the historical premium/discount value meaningless. Nevertheless, the z-score is a good starting point for gauging the sentiment of CEFs. Historical performance Besides having a large and negative z-score, it is also important to consider the historical performance of a fund. The following chart shows the total return performances of CHI, CWB and the SPDR Barclays High Yield Bond ETF (NYSEARCA: JNK ) since early 2009, the inception date of CWB. CHI Total Return Price data by YCharts We can see from the chart above that CHI has remained competitive with CWB and JNK from early 2009 to the start of 2015. As the premium/discount of CHI remained within a narrow range of +5% to 5% during this time, the price total return profile of CHI during this period roughly approximates its NAV total return profile during this time. The outperformance of CHI over CWB and JNK during rising markets is expected due to CHI’s use of leverage. Moreover, CHI has posted respectable NAV returns since inception in 2002. The following chart shows the annualized price and NAV returns of CHI over various historical time periods (source: Calamos). We can see that CHI’s historical performance has been very strong, with a 10.0% annualized return since 2002, and a 10-year annualized return of 7.3%. Keep in mind, however, that CHI uses leverage, which is currently at 28.34%. Distribution CHI pays a monthly distribution of $0.095, representing an annualized dividend yield of 10.92%. The following chart shows the dividend history of CHI since inception (source: CEFConnect). (click to enlarge) The dividend has been remarkably stable since 2008. However, one warning sign is that the fund has been paying out some of its distributions from return of capital over the past 12 months. My calculations show that 19.8% of the past year’s dividends consisted of return of capital. If this continues, the return of capital distributions will either erode CHI’s NAV, or force a distribution cut. Summary The sell-off in the CEF space has pushed CHI’s discount to levels not seen since the financial crisis. The extreme 2- and 4-year z-scores in excess of -3.5 indicate severe pessimism regarding the fund. Purchasing CHI now allows an investor to lock in a higher yield as well as the opportunity for capital appreciation if mean reversion takes place. Moreover, CHI has a strong historical track record since 2002, and its expense ratio is also reasonable. Risks of CHI include interest rate risk and credit risk of the underlying holdings, as well as a further widening of the discount value. The former risks can be somewhat reduced by pairing a long position in CHI with a short position in CWB and/or JNK, but the latter risk remains. (See my previous articles here and here for previous examples of where mean reversion allowed annualized profits of ~20% to be made on CEF pairs trades). Disclosure: I am/we are long CHI, CEFL. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.