Virtus Convertible & Income Fund II (NCZ-PA)

Virtus Convertible & Income Fund II is a closed-end investment fund managed by Virtus Investment Partners. The fund invests in convertible bonds, preferred stocks, and other hybrid securities designed to generate income while offering some appreciation potential. Closed-end funds differ from the mutual funds most retail investors know: they raise a fixed amount of capital at inception (by selling a set number of shares) and then manage that pool without having to handle ongoing redemptions. The trade is that shares trade on an exchange like a stock, and the share price can diverge from the underlying net asset value if demand shifts.

What the fund buys

The fund’s portfolio is built around convertible bonds — debt instruments that pay interest like ordinary bonds but can be converted into equity shares at the bondholder’s option. A convertible bond from a technology company, for example, might pay 3 percent interest annually and allow the bondholder to convert into common stock at a strike price. If the stock rises above that strike, the bondholder has the option to convert and capture the appreciation. If the stock falls, the bondholder keeps receiving the 3 percent coupon and has protection from the bond’s face value.

Convertible bonds appeal to investors seeking both income and some stock upside. They typically pay lower interest than straight corporate bonds because of the conversion feature. The fund also holds preferred stock — a security that sits between bonds and common stock in seniority and typically pays a fixed dividend. Preferred stock can have call provisions, allowing the issuer to redeem shares if rates fall, which limits upside but protects investors if interest rates rise.

By concentrating on these hybrid securities, the fund positions itself to benefit from both a strong equity market (convertibles capture some stock upside) and a period of rising or stable credit spreads (convertible bonds gain value when default risk falls). It is a bet on moderate credit conditions and stable equity valuations rather than rapid growth.

Leverage: the amplifier and the risk

What distinguishes Virtus Convertible & Income Fund II from a simple convertible-bond mutual fund is its use of leverage. The fund borrows money and invests that borrowed capital alongside shareholder capital, amplifying both gains and losses. If the fund’s portfolio rises 10 percent and the fund has borrowed an amount equal to 30 percent of its assets, the return on shareholder equity is magnified.

Leverage is a double-edged tool. In good markets, it amplifies gains. When convertible bonds and preferred stocks are rising, a leveraged fund outperforms an unleveraged peer. But when markets fall, leverage cuts both ways. A 10 percent portfolio decline on a leveraged fund can wipe out a much larger share of shareholder capital because of the borrowed money. Leverage also requires the fund to pay interest on its borrowings, a cost that reduces returns in stable or down markets.

The leverage ratio — how much the fund has borrowed relative to shareholder capital — can change as asset values move. Markets down, leverage ratio up (because the equity base shrank). Markets up, leverage ratio down. The fund manages this actively, sometimes adjusting the amount borrowed to keep the ratio within target ranges. In volatile or stressed markets, the fund’s creditors might demand repayment more quickly, forcing the fund to sell assets at unfavorable prices.

Distribution policy and yield premium

Closed-end funds trading at a discount to net asset value often offer attractive yields. NCZ-PA targets a high distribution yield to shareholders, funded by the income from the portfolio (coupon payments and dividends) plus realized capital gains and potentially some return of capital. The advertised yield is attractive relative to bond or stock yields because it includes the leverage effect. A 5-6 percent distribution yield on a convertible-focused fund might look appealing next to a 2-3 percent yield on a traditional bond fund or common stock, but that higher yield is partly a function of the borrowed capital and the portfolio’s credit risk.

Investors must distinguish between sustainable yield and yield that includes return of capital. Some distributions are paid from actual portfolio earnings. Others return shareholder capital to shareholders under the guise of a distribution — a practice called return of capital. The fund’s disclosure documents explain the composition of each distribution, but most shareholders do not read them carefully. Yield that is funded by returning shareholder capital is not a true income return; it is a partial liquidation.

Market price versus net asset value

Because closed-end funds are traded like stocks on exchanges, their share price can diverge from the underlying net asset value per share. In periods when closed-end funds are in demand (often when equity markets are strong and risk appetite is high), funds trade at a premium to NAV. In risk-off periods, they trade at discounts.

NCZ-PA typically trades at a modest premium or discount depending on market conditions and investor appetite for leveraged yield strategies. Shareholders who buy at a premium are betting that the fund’s performance and the discount will shrink enough to deliver a positive return. Those who buy at a discount capture the appreciation as the discount narrows, assuming it does.

Performance drivers and risks

The fund’s returns depend primarily on three factors: the performance of the convertible bond and preferred stock markets, the cost of leverage (the interest the fund pays on borrowed money), and changes in the premium or discount to NAV. In years when convertible bonds appreciate and leverage costs are low, the fund tends to outperform. In years when convertibles decline or leverage costs are rising, the fund underperforms.

The main risks are credit risk (some of the convertible bonds in the portfolio could default), interest-rate risk (rising rates hurt bond prices), equity-market risk (if stocks fall sharply, the conversion option in convertibles becomes worthless), and leverage risk (a market stress that forces the fund to sell assets into weak prices or hurts the fund’s ability to borrow). A severe market downturn can trigger a cascade: convertible bonds fall, preferred stocks fall, and leverage forces the fund to sell at losses. Shareholders bear the brunt.

The fund is not a passive holder. Virtus’s portfolio managers make security-selection decisions, trying to identify convertibles and preferreds that will outperform. The quality of that investment judgment affects returns, and the fund charges management fees (typically 0.5–1 percent annually) for those services.

How to research Virtus Convertible & Income Fund II

Start with the fund’s annual report and fact sheet on the Virtus website or the fund’s prospectus (SEC CIK 0001227857). These documents detail the portfolio holdings, the leverage level, and the distribution policy. Look at the fund’s annual returns and compare them to a simple convertible-bond index to see whether active management has added value.

Watch the fund’s market price and net asset value. A persistent premium or discount is useful information — discounts suggest temporary weakness in demand for the fund, while premiums suggest demand is strong. A widening discount can signal deteriorating fund performance or rising fears about leverage.

Pay close attention to the distribution payment history. If most of the distribution is return of capital, the yield is largely an illusion. If most is paid from portfolio earnings, the yield is more sustainable. The fund publishes this breakdown in annual disclosures.

Understand that this is not a buy-and-hold-forever holding. Closed-end funds with leverage are tactical positions, useful when convertible bonds are pricing attractively and leverage costs are low, but potentially problematic in risk-off markets or rising-rate environments. The fund’s performance depends on both portfolio management and market conditions. For investors comfortable with leverage and seeking higher current income at the cost of higher volatility, it can be a useful component of a diversified income portfolio. For conservative investors, it is probably too volatile.