Performance Overview: In the third quarter of 2023, the Absolute Convertible Arbitrage Fund (ARBIX) achieved a positive return of +0.83%. This performance adds to the fund’s overall year-to-date return, which now stands at +3.69%.

Challenges Amidst Rising Interest Rates:
Investing in various bond strategies continued to be a challenge due to the persistently higher interest rates observed during the quarter. These rate increases were fueled by robust economic and inflationary indicators. Notably, the 5-year Treasury yield, which influences shorter-duration corporate bonds like convertibles, surged to 4.61%, marking a 45 basis point rise during the quarter and a remarkable 400+ basis points increase from 2020. This surge in rates during the third quarter had an adverse impact on bond strategy returns, as evidenced by the -3.23% decline in the Bloomberg AGG index during the period.

Distinctive Resilience of Convertible Arbitrage:
As discussed in the second quarter commentary, convertible arbitrage stands apart as a distinct/alternative bond strategy. The strategy is resilient because market forces like interest rates, credit spreads, and equity volatility, often counterbalance each other. This can result in consistent returns even in challenging market conditions. Despite the headwinds posed by higher rates and reduced volatility among smaller-cap stocks (as indicated by the drop in 30-day volatility for the Russell 2000), the strategy benefited from higher Fed Funds rates. Higher rates contributed to increased positive carry and helped to offset the broader market challenges.

Breakdown of Fund Performance:
Looking at the fund’s gross Profit & Loss (P&L) for the quarter, several key factors contributed to its performance:

•   Appreciation of convertible bond prices relative to underlying stock hedge added +11 basis points.
•   The interest rate hedge contributed +12 basis points.
•   Trading activities accounted for +11 basis points.
•   Yield/carry provided a significant boost with +79 basis points.
•   Notably, the improved yield/carry played a pivotal role in delivering positive returns.

Convertible New Issuance:
In the third quarter, there were 20 convertible deals priced, raising a total of $12.6 billion in proceeds. Year-to-date, there have been 71 deals completed, raising a cumulative total of $40.5 billion (source: Kynex). While new issuance was somewhat slower than expected due to factors such as lower stock prices and persistently low volatility among small/mid-cap stocks, it’s worth noting that 2023 issuance has already exceeded that of the entire previous year.

Lower stock prices and stubbornly low volatility among small/mid-caps is likely keeping issuance a bit lower than expected as companies have less ability to monetize the embedded equity call option associated with a convertible. It is difficult to know precisely what to expect for issuance in the fourth quarter and 2024. But if equity volatility picks up and/or long only investing in small/mid-caps awakens, more companies may choose to issue convertibles instead of straight bonds because of the high interest rate environment.

Market Outlook and Caution:
The Federal Reserve remains committed to addressing inflation concerns. While it’s possible that we are witnessing the peak (or near peak) of fed funds rates, the market anticipates that short-term rates will remain elevated for an extended period. Again, this environment has bolstered the carry return in our strategy, which has become increasingly significant.

However, we maintain a cautious stance in our portfolio positioning. Sustained higher rates can take time to impact the broader economy. It is reasonable to assume that such rates could eventually negatively affect company margins and refinancing costs, potentially resulting in heightened credit stress and increased default rates. Nevertheless, the wider credit spreads typically associated with such periods are often accompanied by higher realized equity volatility, which would provide a counterbalancing force.

Portfolio Positioning:
In response to these dynamics, we are committed to maintaining a well-diversified portfolio and gradually placing greater focus on heavily hedged, strong credit, higher carry investments that can thrive in a high-interest rate environment, benefit from higher realized equity volatility and also withstand potential economic slowdowns.

ARBIX continues to navigate the challenges presented by rising interest rates and evolving market conditions, challenges that could eventually mean a significant economic slowdown. With a focus on bottom-up credit research, prudent diversification and a disciplined hedged strategy, the fund remains poised to consistently navigate the shifting financial landscape with a focus on capital preservation.

(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.

These views are subject to change at any time based on market and other conditions, and Absolute Investment Advisers disclaims any responsibility to update such views. No forecasts can be guaranteed. These views may not be relied upon as investment advice or as an indication of trading intent on behalf of any Absolute Investment Advised investment product.

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.

Distributor: Ultimus Fund Distributors, LLC