The Absolute Convertible Arbitrage Fund (ARBIX) returned +0.18% in the second quarter of 2021. The year-to-date return through 2Q 2021 stands at +1.43%.

Convertibles are hybrid securities simultaneously affected by a number of embedded factors that drive performance. These factors include credit spreads, volatility, risk free rates, stock loan rates, money flows/supply and demand, new issuance, secondary trading opportunities, takeovers, exchanges, buybacks, etc. Credit, volatility and interest rates are the dominant three forces that affect long term valuations while money flows/supply and demand push theoretical valuations around in the short term.

Overall high yield credit spreads tightened further in the second quarter and were supportive of credit throughout the high yield straight bond market, but this did not spill over and support credit spreads in convertibles. The Barclays US High Yield B spread tightened 39 basis points and ended the second quarter at 294 bps. However, non-investment grade convertible bond implied spreads remained much wider than high yield ending the quarter at 439 bps.

Risk free rates (specifically, the 5-year US Treasury which most closely matches the duration of the convertible bond market), were a neutral factor for convertibles basically ending the quarter right where they started. However, market sentiment regarding the Fed’s handle on inflation expectations does seem to wax and wane with more frequency as the economy continues to reopen with less issues around Covid. ARBIX, despite being a short duration portfolio of small/mid cap hedged trades, where credit and vol have the greatest impact, continues to maintain a portfolio interest rate hedge in case we experience an unexpected jump in risk free rates before the expected 2022 Fed tapering.

The average convertible bond price now stands at >130% of par making the typical convertible arbitrage trade volatility sensitive. The major headwind for convertible arbitrage in 2Q 2021 was the precipitous decline in realized underlying equity volatility. The Fed backstopped, benign risk environment enveloping the US markets, had a dramatic impact on reducing equity volatility as stocks continued to grind higher with little worry about downside risk. The 30 day historical vol for the Russell 2000 was cut in half in 2Q 2021, beginning the quarter at 33 and ending at 16. The same was true for larger stocks as 30 day vol for the S&P 500 was also cut in half. The decline in volatility made it very difficult for arbitrageurs to monetize changes in delta hedges in the quarter and lower future vol assumptions directly affected the embedded calls of convertibles pressuring theoretical values.

The convertible market also continues to absorb all the heavy new issuance over the past 18 months which has pressured valuations and cheapened convertible theoretical valuations – especially among non-investment grade convertibles which now trade at about a 1.4% discount to theoretical value. Longer term, new issuance is great for the convert market because it keeps prices below fair value and provides a large, diverse, long term opportunity set with a wide variety of company securities to choose from.

Convertible arbitrage is a bond strategy that offers multiple ways to generate returns but does have an opportunity set based on where interest rates and credit spreads are currently priced. It is also dependent on convertible valuations and the ability to monetize underlying equity volatility. Even though volatility has been very difficult to monetize of late, the good news is that secondary convertible bond prices now reflect substantially reduced volatility assumptions going forward which could provide some unexpected upside if volatility rebounds. And even though credit spreads are generally tight throughout the capital markets, convertible spreads still offer significant relative value despite much lower historical default rates than high yield. And, last but not least, almost all other bond strategies have significant interest rate risk with rates still near historical lows while convertible arbitrage has limited sensitivity to rate movements (see Table 1 on page 2).

In summary, finding a bond strategy that currently offers some return potential above inflation without taking on significant downside risk is difficult to say the least. ARBIX can generate returns from credit spread compression over time (as converts approach maturity/call dates), current yield, volatility monetization, theoretical discounts to fair value, or from trading. Consistent with the Fund’s investment objective and principal investment strategy, the Fund’s Adviser views convertible arbitrage as a low volatility strategy that is intended to achieve fixed-income-like returns with lower than equity market risk by managing a portfolio that it believes will exhibit less volatility over full market cycles. It may be difficult to get excited about moderate return expectations when constantly distracted by the never ending upside in equities, but ARBIX may offer compelling risk/reward versus other options in corporate credit. ARBIX is a hedged credit portfolio using no leverage, offering daily liquidity, with low sensitivity to interest rate movements. And if volatility rebounds, there is further upside with volatility now priced low and convertible valuations significantly below fair value.

(Definitions, supporting data and risk disclosure below)

government regulations, differences in accounting standards and other factors. Investments in emerging markets involve even greater risks. Small, mid and large cap stocks are subject to substantial risks such as market, business, size volatility, management experience, product diversification, financial resource, competitive strength, liquidity, and potential to fall out of favor that may cause their prices to fluctuate over time, sometimes rapidly and unpredictably. The Fund is actively managed and may experience high turnover. This may cause higher fees, expenses and taxes, which could detract from Fund performance.

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Investors should carefully consider the Fund’s investments objectives, risks, charges and expenses before investing. This and other information is in the prospectus, a copy of which may be obtained by calling (888) 992-2765 or visiting the Fund’s web site: www.absoluteadvisers.com. Please read the prospectus carefully before you invest.