The Absolute Convertible Arbitrage Fund (ARBIX) returned -3.07% in the second quarter of 2022. Year-to-date the fund has returned -3.59%.

2022 continues to be a year of stiff headwinds for almost all securities, including convertibles. In more normal times, the hybrid nature of convertibles provides some natural resilience to specific, individual market forces acting up such as higher rates, wider credit spreads or weak equities. But when all three are moving in a negative direction, even a portfolio of hedged convertibles can struggle to provide positive returns. However, when compared to other alternatives in fixed income, credit and equities this year (many of which are down double digits), the fund has again demonstrated its ability to control downside risk.

The first quarter of 2022 was dominated by rising interest rates pressuring bond investments across the board. Even though treasury yields continued to rise in the second quarter of 2022, the larger headwind this past quarter was the weakening in credit markets as high yield spreads widened by more than 200 basis points. In addition, sentiment around equities continued downward with the Russell 2000 posting its worst- ever first half of a year. YTD, unhedged convertibles are down almost -20% for the year, primarily because the underlying equities for convertibles continue to underperform at -33.5% ytd. As a result, valuations for convertibles have cheapened well below fair value as sellers have forced down prices. In summary, almost nothing has been supportive of returns so far in 2022.

From an overall gross P&L perspective for the quarter, convertible bond price depreciation versus the underlying stock hedge had a negative impact of about -337 basis points, while the interest rate hedge positively contributed about +20 basis points, yield/carry +33 basis points, and trading +7 basis points. Convertible theoretical valuations continued to cheapen in the second quarter as sellers were pervasive and a risk-off attitude toward credit risk became the dominant influence.

Given that the Federal Reserve Committee will likely keep its feet forcefully on the brakes until it has inflation under control, our capital preservation mindset will carry on. In practice, this means we will not try to time a market bottom. Instead, we will continue to slowly deploy excess cash and pick away at our highest conviction trades at the right prices – gradually and prudently setting ourselves up for the longer term. Even though convertible valuations are very attractive currently, it could take more time to reach absolute bottom simply because the Fed is not supportive of markets unlike the swift bounces experienced in past years following similar declines in 2020 or 2009. An obvious requirement of our job is to monitor the macro forces pushing markets around and understand how those forces can persist. However, more importantly, we will stay extremely focused on individual companies and keep our bottom-up credit focus as the dominant input in our decision making – remaining undistracted by the noise.

The good news is that the annualized expected return for the strategy has moved significantly higher because of the recent repricing in the overall markets and in convertibles. The average implied credit spread for convertibles is now above 6% and the risk free rate has risen to around 3% versus 1.25% at the start of 2022. Additionally, because we short underlying convertible stocks as part of our hedged strategy, and thanks to the Federal Reserve raising rates, we now receive a positive rebate on our short stock proceeds. This improved rebate will generate more positive carry going forward in addition to new convertible issues that will be coming to market with higher coupons than years past. It is also important to note that the portfolio’s underlying companies continue to perform well with no meaningful deviations from our expectations in recent earnings announcements.

2022 will likely continue to test investor patience and conviction across all investments. Without knowing when inflation will be under control, or the cost to the economy of bringing inflation down, it is nearly impossible to pick a market bottom. Fortunately, our strategy is hedged, tightly risk controlled and not reliant on making short-term macro predictions. Even though it has been a struggle so far in 2022, our decades of experience and along with our capital preservation mindset, will continue to serve us well in controlling downside risk while continuously looking to capture under-the-radar opportunities that do not come around very often. Accumulating wealth is as much about not losing money as it is about capturing upside. We pride ourselves on doing both.

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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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