Convertible arbitrage may be an attractive alternative for cash, bond, and credit investors. Over meaningful measurement periods, this strategy has delivered low volatility high yield like returns and significantly better returns than cash.
Performance Overview:
In the third quarter of 2024, the Absolute Convertible Arbitrage Fund (ARBIX) achieved a positive net return of +2.61%. Year-to-date, ARBIX has gained +6.27%, and over the past 12 months, the Fund has delivered a +7.91% return. This marks the ninth consecutive quarter of positive returns for the fund, even as interest rate conditions have presented both headwinds and tailwinds for bonds. Other bond strategies that are more correlated to interest rates have shown significantly less consistency than ARBIX.
Market Movement and Impact:
Steadily declining interest rates during the quarter supported bond valuations, with the 5-year Treasury yield dropping 82 basis points. High-yield corporate bond spreads remained neutral to performance, fluctuating but ending the quarter nearly at the same levels they started. Equity volatility spiked briefly due to fears surrounding the unwind of the yen carry trade in early August. While this spike in volatility was beneficial for convertible arbitrageurs, its short-lived nature limited its overall impact on returns.
Generally, 2Q2024 company earnings focused a lot of attention on plans to incorporate AI in their business models going forward. It will be interesting to see how this plays out in the quarters ahead – in terms of actual cost benefits, improved products and whether the attention towards AI continues to accelerate. From a macro perspective, the vast majority of our companies in the portfolio reported earnings close to expectations but some conference call commentary suggests a bit of a slowdown in revenue growth rates ahead.
The portfolio continues to be small and mid cap focused and entirely U.S. based. With the strong performance of the Russell 2000 over the past 12 months, convertibles have gradually moved more “in-the-money”. This means that convertibles have become more equity sensitive with higher delta hedges. In other words, as equity prices move higher, we increase our short equity hedges for each convertible position which means the portfolio is becoming more equity volatility sensitive and less sensitive to interest rates and credit spreads. As of today, the portfolio consists of 41% equity sensitive names, 35% balanced names and 24% credit/interest rate sensitive names. The portfolio has gradually moved in this direction organically because higher stock prices require heavier hedges and more merchandise in the convertible market is trading in this territory (making it more likely to source undervalued merchandise in these names).
Fund Performance Breakdown:
The Fund’s gross Profit and Loss (P&L) for the quarter highlights several contributing factors:
- Appreciation of convertible bond prices relative to underlying stock hedges: +185 basis points.
- Interest rate hedge: -7 basis points.
- Trading activities: +15 basis points.
- Yield/carry: +98 basis points.
Convertible New Issuance:
Convertible new issuance continues to gradually improve. According to Barclays Convertible Research, $58.5 billion of new convertible deals have been priced in the U.S. year-to-date, surpassing last year’s total of $51.6 billion. With convertibles facing a maturity wall of approximately $180 billion through 2026, expectations are high for further increases in new issues, particularly given the popularity of refinancing within the convertible market.
Fed Rate Cuts:
One of the most significant recent developments is that the Federal Reserve has begun to lower the target Fed Funds rate. The first move, a 50 basis point cut on September 18, marks the beginning of what is expected to be a series of cuts in the coming months as inflation numbers continue to subside.
With the Fed cutting short-term rates and longer-term Treasury yields moving lower in anticipation, many investors are reevaluating their cash, high-grade bond, and credit holdings for 2025 and beyond. The FOMC dot plot suggests that cash returns for 2025 are expected to drop another 100 basis points from current levels. Meanwhile, the 10-year Treasury bond is already priced 120 basis points lower from its peak, once again introducing principal and duration risk. Additionally, tight high-yield credit spreads are limiting potential returns in that space.
Convertible Arbitrage Outlook – an alternative place to go:
Convertible arbitrage may be an attractive alternative for cash, bond, and credit investors. Over meaningful measurement periods, this strategy has delivered low volatility high yield like returns and significantly better returns than cash. The forward return expectation spread between convertible arbitrage and cash is likely to widen from here as the Fed continues to cut rates. Convertible arbitrage is a fairly short duration strategy (approximately 3 years) and has a strong history of resilience to rising long-term interest rates, which could occur if the Fed cuts rates too aggressively. Convertibles are also priced at implied credit spreads wider than high yield. According to Barclays, non-investment grade convertible bond spreads stand at 437 basis points, while the Bloomberg US High Yield B-rated bond spread is at 285 basis points—a substantial 152 basis point difference. Lastly, convertibles provide long equity volatility exposure, which tends to offset credit moves and can be a source of substantial profits, particularly if we experience more bouts of equity volatility similar to the one in early August.
(Definitions, supporting data and risk disclosure below)
Quarter-End Performance for ARBIX: As of 9/30/24, the 1 year, 5 year and 10-year annualized performance for the Absolute Convertible Arbitrage Fund was 7.19%, 4.80% and 4.53% respectively.
Performance data quoted represents past performance and is no guarantee of future results. Current performance may be lower or higher than the performance data quoted. Investment return and principal value will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than the original cost. To obtain performance information current to the most recent month-end, call the Fund at 888-99-ABSOLUTE. Returns include the reinvestment of dividends and capital gains. Some of the Fund’s fees were waived or expenses reimbursed; otherwise, returns would have been lower.
As stated in the prospectus, the Absolute Convertible Arbitrage Fund’s Total Annual Operating Expense ratio for Institutional Shares is 1.47% (gross) and 1.41% (net) through July 31, 2025. Absolute Investment Advisers LLC, the Fund’s Adviser, has contractually agreed to waive its fee and/or reimburse Fund expenses to limit Total Annual Fund Operating Expenses to 1.20% through July 31, 2025 (the “Expense Cap”). This Expense Cap, which excludes all taxes, interest, portfolio transaction expenses, dividend and interest expenses on short sales, acquired fund fees and expenses, broker charges, proxy expenses and extraordinary expenses, may only be raised or eliminated with the consent of the Board of Trustees.
HEDGE FUND CONVERSION – In August 2017, a hedge fund managed by Mohican Financial Management LLC reorganized into the Fund. The Fund’s performance for periods prior to the commencement of operations is that of the hedge fund and is based on calculations that are different from the standardized method of calculations adopted by the SEC. The performance of the hedge fund was calculated net of the hedge fund’s fees and expenses. The performance of the hedge fund is not the performance of the Fund, has not been restated to reflect the fees, estimated expenses and fee waivers and/or expense limitations of the Fund, and is not necessarily indicative of the Fund’s future performance. If the performance of the hedge fund had been restated to reflect the applicable fees and expenses of the Fund, the performance may have been lower. The hedge fund was not registered under the Investment Company Act of 1940 (“1940 Act”) and was not subject to certain investment limitations, diversification requirements and other restrictions imposed by the 1940 Act and the Internal Revenue Code of 1986, which, if applicable, may have adversely affected its performance.
DEFINITIONS:
The Bloomberg Aggregate Bond Index
(Bloomberg Agg) is a broad base, market capitalization-weighted bond market index representing intermediate term investment grade bonds traded in the United States. Investors frequently use the index as a stand-in for measuring the performance of the US bond market.
The Russell 2000 is a market cap weighted index that includes the smallest 2,000 companies covered in the Russell 3000 universe of United States-based listed equities. The Russell is by far the most common benchmark for mutual funds that identify themselves as “small-cap.”
A Basis Point (or bps) is 1/100th of a percent.
Past performance does not guarantee future results. The Fund’s net asset value and investment return will fluctuate based upon changes in the value of its portfolio securities. There is no assur- ance that the Fund will achieve its investment objective, and an investment in the Fund is not by itself a complete or balanced investment program. For a complete description of the Fund’s principal investment risks please refer to the prospectus.
Asset allocation decisions may not always be correct and may ad- versely affect Fund performance. The value of a convertible securi- ty is influenced by changes in interest rates, with investment value declining as interest rates increase and increasing as interest rates decline. The credit standing of the issuer and other factors also may have an effect on a convertible security’s investment value. Debt securities have interest rate, inflation and credit risks and are subject to prepayment and default risk. High yield and junk securi- ties involve greater risk and tend to be more sensitive to eco- nomic conditions and credit risk. Short sales may be considered speculative and it may be difficult to purchase securities to meet delivery obligations. The Fund may leverage transactions which include selling securities short as well as borrowing for other than temporary or emergency purposes. Leverage creates the risk of magnified capital losses. Diversification does not prevent loss or enhance returns. Foreign investments present additional risk due to currency fluctuations, economic and political factors,
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
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www.absoluteadvisers.com
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