Capitalizing on Rising Interest Rates and a Slow Grind Up in the S&P 500 Index

Eli Pars, CFA

• We see an attractive opportunity set for convertible arbitrage continuing, supported by rising overnight interest rates and increased convertible issuance.
• CIHEX and the hedged equity sleeve of CMNIX have benefited from the slow grind up in the S&P 500 Index and higher interest rates.
• During the quarter, we reduced CMNIX’s allocation to SPACs and added incrementally to our other arbitrage strategies.

Calamos Market Neutral Income Fund (CMNIX) is designed to enhance a traditional fixed income allocation. The fund combines two complementary strategies—arbitrage and hedged equity—to pursue absolute returns and income that is not dependent on interest rates. During the second quarter, both the arbitrage and hedged equity strategies gained ground.

We actively manage allocations to the strategies based on our view of market conditions and relative opportunities. The fund’s current allocation to the arbitrage strategy is 53%, with 47% in the hedged equity strategy. At the start of the year, the fund’s allocation to the arbitrage strategy was 51%, with 49% allocated to the hedged equity strategy.

Within the arbitrage strategy, we have the flexibility to utilize different strategies, including convertible arbitrage, merger arbitrage and special purpose acquisition company (SPAC) arbitrage.* We continue to like the opportunity in convertible arbitrage most, and the fund’s allocation to this strategy grew from 39% at the start of the year to 46% on June 30. We expect to continue adding to convertible arbitrage, particularly if we see the attractive new convertible issuance that we anticipate.

We funded the increased allocation to convertible arbitrage primarily through a reduction of our SPAC book. SPACs are now 3% of CMNIX, after peaking at almost 10%. While we have sold a few SPACs, the lower allocation is primarily the result of the natural runoff of SPACs issued in 2021 with terms of two years or less.

A principal driver for our bullishness in convertible arbitrage is our heightened return expectations for the strategy on the back of the rise in overnight interest rates. Convertible arbitrage returns have historically been correlated with overnight rates. This is partly because of the direct linkage of the rebate the fund receives on its short stock positions, which is directly tied to the fed funds rate. Although returns don’t necessarily go up tick-for-tick with rates, we expect a meaningful tailwind in 2023 and beyond.

We would buy new SPACs if we saw similar terms to those we bought in 2021. Then, SPACs were profitable for the fund, with limited volatility, and our allocation served the fund well over the past few years. However, the SPAC new issue market has been quiet since late 2021. The gating factor for SPAC issuance is sponsors willing to commit capital in exchange for the opportunity to make a multiple of their investment if they can get a deal across the finish line. This tends to be a bull market trade, and we are not seeing those levels of animal spirits in the small cap space, where most “de-SPAC-ed” equities reside.

The S&P 500 Index's slow upward grind during the quarter also benefited the hedged equity side of the fund. Call volatility has come in a bit recently, but it has generally been higher this year, which has allowed us to generate more income from the options strategy while still having a significant degree of downside risk mitigation. Higher interest rates also have flowed through to the hedged equity strategy in the form of higher call prices and lower put prices, making our collar strategy more attractive. Also, a relative bid to tail risk has made put spreads an attractive tool for us to layer in extra downside risk mitigation.

Calamos Hedged Equity Fund (CIHEX) is an equity alternative designed to help investors dampen the impact of equity market volatility and drawdowns. As discussed above, the S&P 500 Index’s slow grind up in the quarter was profitable for CIHEX. In addition to benefiting from its net long exposure in a rising market, elevated call volatility allowed us to generate more income from the options strategy without sacrificing significant downside risk mitigation. Although call volatility has come in recently, we have been taking advantage of this bid to call volatility while still maintaining lighter-than-usual use of call writing. We also continue to layer in put spreads over and above our typical minimum level of notional long puts to provide additional downside risk mitigation. Finally, as noted above, higher call prices and lower put prices have made our collar strategy more attractive.