The Absolute Convertible Arbitrage Fund (ARBIX) returned +1.94% in the fourth quarter of 2022. The fund return for all of 2022 was -0.53%.

Buyers finally returned to convertibles in the fourth quarter of 2022 as an attractively repriced market brought back some investors after 9 months of mostly selling. A more stable backdrop for interest rates, credit spreads and equity prices supplied much needed confidence for investors to put cash to work in repriced securities without feeling like they are catching a falling knife. After enduring terrible conditions for most of 2022 where there was almost no place to hide because of aggressive rate hikes by the Federal Reserve, there is now a sense that much of the pain is behind us in repricing risk assets. However, there is also a good chance that we could be experiencing a temporary lull and inflation could be more stubborn than we hope.

From an overall gross P&L perspective for the quarter, convertible bond price appreciation versus the underlying stock hedge had a positive impact of +159 basis points, while the interest rate hedge was flat, yield/carry contributed +49 basis points, and trading +16 basis points. Convertible theoretical valuations ended the quarter about 50 basis points below fair value on average, very close to where they began the quarter. As mentioned in the previous quarterly commentary, the repricing of the convertible market to much higher yields is expected to significantly enhance expected returns for the strategy going forward. We saw that start to take shape in the fourth quarter of 2022.

2022 was a tumultuous year in the markets, to say the least. Capital preservation skills became front and center in evaluating managers of all strategies, including convertible arbitrage. High yield spreads widened by 180 basis points in 2022, the 5 year treasury yield jumped almost 300 basis points and underlying equities for convertibles dropped by more than 30%. Non-investment grade convertible spreads widened even more than high yield ending the year close to 200 basis points wider than high yield despite having significantly lower historical default rates (Barclays). Essentially, risk free rates, credit spreads and equity prices were all dramatically repriced as the Fed raised the fed funds rate by 400 basis points.

We are proud of the fact that we were able to preserve capital in 2022 when most bond strategies were down double digits for the year (see table on reverse). At the start of 2022, we made it clear that we were concerned about the markets and were therefore going to be cautious in our approach. In our fourth quarter commentary of 2021, we said “we could be at a major inflection point for long only investments as they could face years of stiff headwinds from the Federal Reserve. Alternative, hedged, actively managed, niche, idiosyncratic strategies could quickly become the best way to preserve capital and make modest positive returns without “fighting the Fed.””

Even though much of the Fed’s work is now in the rear view mirror, there is no certainty that inflation has been conquered despite the treasury market recently acting as if the Fed should be done. Regardless, the great repricing of 2022 is mostly done which puts convertibles in a much better position to make returns in the years ahead. Average convertible yields (greater of ytm/ytp) have jumped more than 400 basis points in less than 2 years. Also, convertibles now reflect an underlying risk free rate that is 300 basis points higher too. Fed Funds rates at over 4% now greatly enhance the stock rebates received on our stock shorts adding an additional source of return that was actually negative just 2 years ago.

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