“Any volatility that isn’t credit-related is usually good for us,” said Co-Portfolio Manager David O’Donohue at the start of last week’s Calamos Market Neutral Income Fund (CMNIX) call. O’Donohue and Eli Pars, Co-CIO, Head of Alternative Strategies and Co-Head of Convertible Strategies and Senior Co-Portfolio Manager, provided a timely update on how the fund—the top-selling alternative fund of 2021—has fared since the start of the year (listen to the call in its entirety here).
O’Donohue named the rise of high frequency traders as liquidity providers, the possible removal of the Fed put and the influence of retail traders as among the array of factors driving today’s volatility.
For as much volatility as has been seen in the S&P 500, it’s been even more pronounced in single names, O’Donohue said. “We’ve seen names like Snap, Facebook, Peloton, Netflix with 20%, 30%, even 50% moves on earnings. Those moves historically have been more like 7%-10%, maybe 20%, and today a 20% move on earnings doesn’t even make the radar some days.”
“Add all of these up and it creates a market that has long periods of stability and then when we see dislocations, the market is a lot more fragile and those moves get magnified.”
It’s this kind of environment—relatively stable with pockets of heightened volatility especially in single names—that creates opportunities for the fund’s principal strategies: convertible arbitrage and hedged equity, O’Donohue said.
“In a convertible arb strategy,” he explained, “we own a bond and we short shares of that, and we short those shares to neutralize the stock move component of it. And then as stocks rise, we need to sell more shares, and as they fall, we need to buy some of those shares in.
“And so, we’re constantly selling as markets rise and as stocks rise, and buying as they fall, and so more volatility and more big moves create more opportunity for us to sell high and buy low or buy low and sell high, and we can actually turn that volatility directly into realized profits. And,” O’Donohue added, “volatility is also a direct input that goes into valuing converts, so the higher the volatility, the more valuable the option component of that convertible bond is.”
Pars was asked to explain the difference between long-only convertibles, whose performance has been weaker this year, and convert arb.
“Convert arb tries to earn a steady return independent of the market,” he said. “We’re buying the convert; we’re shorting the underlying stock. We rebalance our hedge as the stock moves, so the more the stock moves, the more we’re selling stock out when it moves up and buying it back when it moves back down, so that volatility is one of the key drivers and returns for the strategy.
“Long-only converts,” he continued, “is directional. You’re trying to get exposure to the equity market with less volatility. Historically, long-only converts have been able to, over whole market cycles, earn returns similar to the equity markets with less volatility.
“There are occasional tactical opportunities in the convert market, but there’s always a strategic reason why you want long-only converts as part of your asset allocation.”
”The challenge is you need to hold it for a whole market cycle, which is why we always say that we think there are occasional tactical opportunities in the convert market, but there’s always a strategic reason why you want long-only converts as part of your asset allocation.”
The “growthier” underlying equities in the convert market have been hit hard in the first six weeks of the year, Pars acknowledged, and that’s flowed through to the performance of converts. But converts have held up.
“A good measure of how converts are holding up is how well the convert arb guys are doing. Are they making money or losing money?”
The answer, according to Pars: “We’re flattish in convert arb year to date. So, that means converts are holding up, but not necessarily outperforming the drawdown in equities. This isn’t necessarily too surprising. It’s still a relatively shallow drawdown even though some individual name moves have been quite dramatic.”
“We tend to see the market pull back and converts move down—what we call dollar neutral. So, with minimal P&L effect, but the converts theoretically cheapen, and that serves as a tailwind for us in the following quarters. We’re seeing a similar move in the market today."
On the hedged equity strategy, the team uses market moves to opportunistically layer in pieces for the fund’s hedge.
“On days like today we’re asking, can we cover some of the calls we wrote? Can we monetize any extra puts we might have? Maybe we can roll some puts down to take some money out but keep protection if things keep going lower. And if we get a big rally back tomorrow for whatever reason, we’ll look to see if we can unwind some of those trades. Maybe we can add in some new puts that are cheaper with volatility down and the market higher.”
“We have a book of equities, and we need a hedge, but the structure of that hedge is really determined by market environment,” said O’Donohue. “A lot of hedged equity strategies or simple covered call strategies, they end up being short volatility. But the way we manage ours, we can end up being more opportunistic about it and being long volatility by nature.”
When the call was taking place the morning of Feb. 17, the market was headed down and would close 2.11% for the day.
“On days like today,” O’Donohue said, “we’re asking, can we cover some of the calls we wrote? Can we monetize any extra puts we might have? Maybe we can roll some puts down to take some money out but keep protection if things keep going lower. And if we get a big rally back tomorrow for whatever reason, we’ll look to see if we can unwind some of those trades. Maybe we can add in some new puts that are cheaper with volatility down and the market higher.”
“We know one of the things people really like about this fund is its really stable, steady, low volatility return stream. Quite frankly, that’s easier in times like 2017 or even last year. But one thing to consider is that higher volatility really does create more opportunity for us. It’s a better environment for us to add alpha and a more target-rich environment. The offset is, it’s just a little bumpier ride.”
The call also covered the team’s use of SPAC arbitrage, which is an opportunistic strategy introduced in the first quarter of 2021. Pars described it as a “compelling” opportunity that has since made up 9.1% of the fund as of 12/31/21.
As explained previously (see this post), the original opportunity involved the typical SPAC coming to the new issue market with $10 in trust and a unit of one share and—with the trust value behind it—and one-third of a warrant. The warrant was typically struck at $11.50 vs. the $10 issuance price of the share.
“We think there’s theoretical value in the warrant that’s not being reflected there, as well as some optionality in the stock because you know you’re going to get your $10 back, and a two-year term was common. We thought there was $10.50 to $11 of value in that structure, and we were buying it for $10, with our downside being we get $10 at the end of two years. A little bit of time value of money cost, but in a zero-rate world that’s not so expensive. And a little bit of mark-to-market risk but, again, not a lot because you’ve got that $10 redemption value to hold up supporting value of the share.”
SPACs represented less than 4% of the fund in the first three quarters of 2021. And then, starting in October, the SPAC sponsors began to sweeten the deals.
“We started seeing new structures come to the market where instead of just the $10 in trust, it was $10.15 or $10.20 in trust with the extra money coming from the sponsor of the SPAC ponying up extra cash,” Pars said. “Now all of a sudden, instead of a one-third warrant, it was a half-warrant, and instead of two years, it was 15 months or 18 months. So, we’ve shortened the time from when we can cash in the SPAC at the end of the term. We still paid $10 for it, but now it’s called $10.20 on average in trust, and a little more warrant coverage is part of the package.”
Pars also touched on the negative press about SPACs. That’s about de-SPACs, he clarified, after the SPAC is merged with the company and launched as a newly traded public company.
“We’re out of the trade by that point—definitely out of the shares and usually out of the warrants, but the warrants are a small part of the overall package.”
The SPACs strategy doesn’t add material equity risk to the portfolio, according to Pars, who adds that the risk profile is similar to the convert arb strategy. “Arguably, it’s lower risk, especially with the overfunded trusts in the market now, and maybe a slightly higher return potential,” he said.
The team likes the opportunity for now, Pars said, adding that it remains to be seen how long the opportunity will be available.
Investment professionals, for more information on CMNIX, contact your Calamos Investment Consultant at 888-571-2567 or email@example.com.
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The principal risks of investing in Calamos Market Neutral Income Fund include: equity securities risk consisting of market prices declining in general, convertible securities risk consisting of the potential for a decline in value during periods of rising interest rates and the risk of the borrower to miss payments, synthetic convertible instruments risk, convertible hedging risk, covered call writing risk, options risk, short sale risk, interest rate risk, credit risk, high yield risk, liquidity risk, portfolio selection risk, and portfolio turnover risk.