The Arbitrage Fund (USD) gained 0.21% in January bringing the rolling annual return to 12.99%.
By the middle of January, the posture of financial markets turned negative, pushing two of our themes into a small loss for the month. Two themes were neutral in their impact on the performance of the portfolio and the remaining two were sufficiently profitable to provide a positive return overall.
Convertible Arbitrage requires an assessment of stock valuations, credit spreads, interest rate movements and changes in volatility in order to identify opportunity. In January, volatility rose, as did credit spreads while interest rates and equity valuations fell. To complicate matters, all of these net changes on the month followed a period of change in the opposite direction in the first two weeks of January. One of our managers was caught out by the reversal and his returns pushed the theme into deficit. Merger Arbitrage was subject to a similar small scale negative impact from choppy price action.
By contrast, Fixed Income Arbitrage managers generally found the environment constructive. Sovereign credit is the big story everywhere. The fundamentals are the ultimate drivers of markets, but politics plays a big part too. In the Greek example, even if a Franco German bailout is the most likely finale, the interplay over the ‘remedies’ Greece must endure in the meantime produces market stress and market anomalies in equal measure. Analysts of the fundamentals look for the next most vulnerable credit. January witnessed a sharp increase in interest in buying long dated payer options in $ & £. Japan is a cheap market in which to bet on higher long term rates. Interest in this area increased too. There are also reports of a revival in the creation of structured product purporting to enhance yield for retail savers. These conjure the necessary ‘yield’ from selling volatility. Their reappearance provides additional opportunities in this theme, even if it seems unlikely that the ultimate retail investors in question will get the outcome they have signed up for.
In Mortgage Arbitrage, January was a profitable month for our managers but February is proving to be more of a challenge. The majority of US mortgages are guaranteed by Agencies originally sponsored by Government and now effectively owned by the US taxpayer, GNMA (Ginnie Mae), FNMA (Fannie Mae) and FHLMC (Freddie Mac). The agencies buy back delinquent mortgages out of the pools of assets they have guaranteed. A proportion of these mortgages have been split into two, separating entitlement to receive the interest (Interest only – IO’s) from the right to the principal repayment stream. Fannie and Freddie have announced their intention to accelerate the buyback of damaged loans for which they are ultimately liable, reducing the number of coupons which the IO holders will receive and so reducing the value of these securities. In a sense, this heralds the end of the period in which spread capture was the best tactic for mortgage managers to employ. But we believe that both of the funds in which we invest have constructed their portfolios to include a range of idiosyncratic risks that offset one another and will not suffer lasting harm from this policy shift.