Convertible Bond Arbitrage strategy

Written by Melissa Nathan, Paris, France

Convertible arbitrage is an investment strategy, which involves buying positions of convertible securities against short positions sale of shares that can be converted.

To understand how this works it is important to know what are convertible securities. These are securities that can be replaced to another time and at a price set in advance. In most cases, the term refers to bonds convertible into shares. Convertible bonds are considered bonds partly influenced by shares, which are both hybrid securities with characteristics. A lower yield is possible than other bonds, but they are compensated in the fact that they are convertible into and when the stock market rises, the convertible debt will rise but less from the stock market. In fact, the purchase of convertible bond enables the investor to get in touch when the stock price rises as well as it being worthwhile to convert. Similarly, when a stock has suffered declining, convertible bonds fell by less than the decline in the price of the underlying stock.

Against the purchase of convertible securities, generally convertible bonds, performing short sale of the shares of that company to reduce or eliminate the exposure of share prices changes in strategy. This strategy is designed to reduce the risk that if the share price falls, short interest income will reduce or eliminate the losses from the bonds. The strategy allows achieving profit by taking a relatively low amount of risk.

Hedge funds through converted arbitrage try to find convertible bonds that tend to fall by less than the amount invested in the underlying shares and cost more than the amount invested in the underlying shares when the market rises.

Below is an example of such an implementation strategy
Hedge fund buys $ 1,500,000 units of convertible bonds that give a company the right to convert the debentures 120,000 shares at their market value $ 10 per share. The hedge fund decides to sell 120,000 shares to reduce and even eliminate the risk of fluctuations in the share price.
If the share price falls by 20% the bond will fall by 15% as the convertible bonds tends to fall less.
Thus, the loss in convertible bonds will be: 500,000 X .15 = $ 225,000
At the same time, a gain in short selling of the stock which in that short selling strategy 120,000 shares at $ 10 can be generated and whilst at a price of $ 8 can be bought back.
Profit will be generated 120,000 X 2 = $ 240,000.
The total profit of the strategy will be: 240,000 to 225,000 = $ 15,000
If the share price goes up, the strategy will be convertible bonds and profit per share. The company would have to buy the stock than the price it sold short.
The aim of the strategy is to reduce the risk resulting from changes in the share price to yield a profit when it rises or goes down. If there is no change in price, investors benefit from the positive yield of the bond.

Still, convertible arbitrage strategy is not risk-free strategy. Indeed, one example occurred in 2005 when the Arbitrage strategy managers bought convertible bonds convertible into General Motors (GM) and sold short the shares. GM suffered losses when the billionaire investor named Kirk Kerkorian tried to buy the stock tender offer. The losses brought them lowering the rating of the bonds. In such a situation it would generally fall, even stock price, but in this case the tender offer caused the share price to rise to a losing position in both directions.

There are also additional reality and risks that has many limitations. For example, we hold convertible bonds for a while before we can convert them to shares if necessary. Therefore, the success of arbitrage is important to accurately assess and determine whether market conditions will be consistent with the time frame in which the conversion is allowed. Then, the value is affected by changes in other strategy such as lowering the rating of agencies or changes in returns for other reasons
Computational measurement confirms that arbitrage convertible has one of the lowest correlation coefficients prices of shares and bonds of the popular strategies among hedge funds. Indeed, from 1994 to 2009 the correlation between the convertible arbitrage strategy linked to the S&P500 is only 0.32%.
This strategy was widely used in 2008 by the French hedge fund ADI and the fund was largely affected by the crisis. Lehman Brothers and its assets were the main assets of the ADI. They invested in bonds and the products sold by Lehman Brothers. Five of the 47 funds were exposed to ADI's high in Lehman Schroders and therefore these five funds collapsed.

Matmut decided to discontinue the operations of its hedge funds. As an insurance company, owning half the shares of the company that manages OFI, OFI wanted to buy the hedge funds of her Matmut and continue with their activities. On 19 November 2008, they bought a portfolio management company OFI ADI funds. The amount of the transaction was not disclosed.
In 2009, however, the convertible arbitrage strategy was a good performance with a return of 19.12%, but the strategy has not been widely used in other hedge funds as shown in the following table: