CMNIX: Gaining Ground as Bonds Tumble

Eli Pars, CFA

Summary Points:

• Calamos Market Neutral Income Fund outperformed the bond market, which suffered a steep decline.
• Demonstrating the long-term benefits of an alternative strategy with little duration opportunity or risk, the fund remains ahead of the bond market across both recent and longer periods.
• We continue to like the opportunities in hedged equity and convertible arbitrage. The fund’s arbitrage and hedged equity allocations are roughly in line with each other.
• Although returns in the two largest strategies were similar all year, hedged equity had a slightly better fourth quarter, pulling ahead of convert arb for the year.
• With its unique return profile, MicroStrategy provides a case study of the idiosyncrasies of convertible arbitrage.

Performance Overview

For the fourth quarter, the CMNIX gained 1.34%, crushing the bond market, which sold off dramatically as measured by a loss of 3.08% for the Bloomberg US Government/Credit Index. For the calendar year 2024, the fund was up 7.43% while the benchmark index was up only 1.18%.

Investors usually allocate to fixed income to stabilize their portfolios and add predictability. And from that standpoint, many were likely disappointed with how 2024 turned out. However, once again, CMNIX showed its value as a fixed-income alternative, providing a return stream that aligns with what investors seek from bonds. Our approach has been successful because it has little exposure to duration opportunity and, perhaps more importantly for investors seeking consistent return outcomes, little exposure to duration risk, unlike traditional bond funds.

CMNIX Outperformance Versus Bonds

Data as of 12/31/24. Source: Morningstar. Performance data quoted represents past performance, which is no guarantee of future results. Current performance may be lower or higher than the performance quoted. Please refer to Important Risk Information. The principal value and return of an investment will fluctuate so that your shares, when redeemed, may be worth more or less than their original cost. All performance shown assumes reinvestment of dividends and capital gains distributions. The fund’s gross expense ratio as of the prospectus dated 3/1/2024 is 0.97% for Class I shares.

For all of 2024, CMNIX’s arbitrage and hedged equity sleeves contributed favorably to performance. Returns from the two strategies were solid, although hedged equity’s return was slightly higher.

Perspectives on Interest Rate Changes

Throughout the fourth quarter and 2024, changing expectations about what the Fed will do next buffeted equity and bond markets. We are happy to report that changes in the Fed funds rate are not keeping us up at night. We’ve invested through many interest rate cycles and are confident we can continue delivering steady performance.

Calamos Market Neutral Income Fund (CMNIX) Has Outperformed Bonds Across Changing Interest Rate Regimes

Past performance is no guarantee of future results. Source: Morningstar Direct and St. Louis Federal Reserve as of 6/30/2024. “Rates near zero” period includes 3/16/2020-3/16/2022, “Aggressive tightening” period includes 3/17/2022 to 5/3/2023 and “Plateau” period includes 5/4/2023 to 6/30/2024. Returns are cumulative.

As we’ve emphasized before, our strategy doesn’t have much duration risk or opportunity. In contrast, bond funds are driven by changes in the curve. Rates for overnight money will go back down, which will weigh on return expectations, but only slightly. The impact of overnight money on our convert arb book mostly lags. Rebates on shorts come through right away, but coupons take longer. There isn’t a lag in the bond market, and it's possible that the bond market has already priced in a good part of the Fed’s moves.

How We Are Positioned

Between the start and end of the quarter, our strategy allocations were unchanged, although we were active in rebalancing our hedges and booking profits throughout the quarter. Hedged equity represented slightly more than half of the portfolio at the end of the quarter, as it did at the start.

CMNIX Allocation: If It’s Not Broken

Numbers may not total 100% due to rounding.

Hedged Equity Strategy

The final quarter of 2024 saw a US presidential election that ended with a clear-cut winner and sigh of relief that propelled equities higher. Our hedged equity strategy captured an attractive level of the upside and was the biggest contributor to the fund’s performance for both the quarter and the year, despite being defensively positioned. As discussed in our past commentaries, favorable capture has been supported by positive standstill yields in an environment of higher interest rates. As rates move down, the opportunity set will adjust, and we will rebalance accordingly.

Arbitrage Strategy

Convertible arbitrage. Convertible new issuance bounced back sharply in the fourth quarter, with $35.8 billion of new paper coming to market globally. This surge pushed full-year issuance to $119 billion, making it one of the top years of the past decade.

Global Convertible Issuance: Healthy Year-to-Date Levels ($bil)

Source: ICE BofA Global Research. Data through December 31, 2024.

We are optimistic about convertible issuance as we head into 2025. Even now that the Fed has lowered interest rates, convertible securities should remain an attractive choice for issuers seeking to lower their borrowing costs, and we continue to see new convertibles come to market with attractive terms. The value proposition of issuing convertibles instead of straight debt remains compelling.

Convertible Arbitrage Case Study: MicroStrategy

Crypto-currency companies were among the most powerful drivers of issuance in 2024, especially during the fourth quarter. The biggest of these by far is MicroStrategy (MSTR). MSTR’s $6.2 billion of convertible issuance in 2024 may be the most ever by one company in a year. Its wave of new paper culminated with a $3 billion convertible issued in November.

Although MSTR started as a software company and still has that software business today, 99% of the stock’s value (and volatility) comes from its holdings of bitcoin. What began as a small investment of the company’s excess cash into bitcoin has grown to something that looks a lot like a closed-end bitcoin fund.

The company has and continues to issue stock and convertibles, and all of the proceeds are going to buy more bitcoin. It has accelerated this activity as the stock has traded at a significant premium to its underlying bitcoin. The software business is estimated to be worth between $500 million and $1 billion. Real money, but peanuts compared with their $43 billion in bitcoin and MSTRs $72 billion market cap.

The volatility of bitcoin combined with MSTR’s own valuation controversy makes it one of the most attractive convertible arb positions we have seen in a while, and we are positioned accordingly. With realized volatility over 100 and long-dated option volatility north of 80, we believe there are plenty of opportunities to monetize the volatility of the stock.

One of the key factors we consider when entering a convert arb trade is “jump to zero.” Jump to zero is the arithmetic of a long and short position going to zero—in simple terms, it’s the maximum potential loss of the trade. In the case of our current MicroStrategy position, our jump to zero position is in the low 40s as a percent of par. If everything went to zero, we would need to recover about 40 cents on a dollar of bond value to break even.

And while the credit is unconventional, we have the advantage of being short stock against the position in our hedge book, which takes our breakeven recovery in the bonds to around 40 cents on the dollar. This results in a breakeven bitcoin price of less than $7,000 per bitcoin for our position. This calculation does not assign any value to the software business, which could add 5 to 15 cents to recoveries.

Merger arbitrage. Like convertible arbitrage, merger arbitrage is also a bottom-up strategy, and the opportunity set is highly idiosyncratic. We believe merger arbitrage will enjoy more tailwinds in coming years, given the likelihood of a less onerous regulatory environment. We are seeing especially exciting opportunities emerge in the energy sector, in all-stock transactions. Energy M&A has tended to avoid some of the biggest regulatory hurdles that have dogged other industries. We continue to like the opportunity set, and we believe consolidation can continue, opening the door to other interesting deals. (For more, see our post, “Merger Arbitrage: Energized by All-Stock Transactions in Oil & Gas.” )

Closing Thoughts

The quarter and year demonstrated once again that bond market volatility isn’t going anywhere. However, on the bright side, Calamos Market Neutral Income Fund has demonstrated the potential benefits of its alternative approach—one that has historically offered steady performance, including when bonds have fallen short.