Convertible Arbitrage

Convertible Arbitrage refers to the trading strategy used to capitalize on the pricing inefficiencies between the stock and the convertible, where the person using the strategy will take the long position in the convertible security and the short position in the underlying common stock.

It is a long-short trading strategy favored by hedge funds and large-scale traders. Such an approach involves taking a lengthy method in convertible security with a simultaneous short position in the underlying common stock to capitalize on pricing differences between the two securities. Convertible security can be converted into another form, such as a convertible preferred stock, which can be changed from a Convertible Preference share to an Equity share/Common stock.

• Convertible arbitrage is a trading strategy that involves purchasing convertible securities while simultaneously short-selling the underlying stock. This approach capitalizes on price discrepancies between the two instruments.
• This strategy is exposed to various risks, including credit risk, interest rate risk, manager risk, legal provision and prospectus risk, and currency risk.
• Practitioners of convertible arbitrage seek out convertible securities with specific characteristics, such as high volatility, a low conversion premium, minimal or no stock dividends on the underlying shares, a high gamma value, an undervalued convertible, and sufficient liquidity. 

The rationale for adopting a convertible arbitrage strategy is that the long-short position enhances the possibility of gains with a relatively lower degree of risk. If the value of the stock declines, the arbitrage trader will benefit from the short position in the stock since it is equity, and the matter flows in the direction of the market. On the other hand, the convertible bond or Debentures will have limited risks since it is an instrument having a fixed rate of income.

However, if the stock gains, the loss on the short stock position will be capped since the profits on the convertible security will offset it. If the stock is trading at par and not going up or down, the convertible security or the debenture will continue to pay a steady coupon rate, which shall offset the costs of holding the short stock. Another idea behind adopting a convertible arbitrage is that a firm’s convertible bonds are priced inefficiently relative to its stock.

This can be since the firm may lure investors into investing in the debt stock of the firm and hence offer lucrative rates. The Arbitrage attempts to profit from this pricing error.

Also, look at Accounting for convertible bonds.

A critical concept to be familiar with convertible arbitrage is the hedge ratio. This ratio compares the value of the position held through the use of the hedge to the whole place itself.

E.g., if one is holding $10,000 in foreign equity, this does expose the investor to FOREX risk. If the investor decides to hedge $5,000 worth of the equity with a currency position, the hedge ratio is 0.5 (50/100). This culminates that 50% of the equity position is prevented from exchange rate risks.

Convertible Arbitrage is trickier than it sounds. Since one generally must hold the convertible bonds for a specified amount of time before conversion into equity stock, the arbitrageur/fund manager must evaluate the market carefully and determine in advance if market conditions or any other macroeconomic factors can have an impact during the time frame in which conversion is permitted.

For instance, if a fund has acquired a convertible instrument of ABC Co. with a lock-in period of 1 year. However, post one year, the country's Annual budget will be announced whereby they are expected to impose a 10% Dividend Distribution tax on the dividends declared by the company on the equity shares. Such a measure will impact the market and the question of holding a convertible stock over the long run.

Arbitrageurs can fall victim to unpredictable events without limits to the downside effects. One instance was during 2005, when many arbitrageurs held long positions in General Motors (GM) convertible bonds and short positions in GM stock. The expectation was that the present value of GM stocks would fall, but the debt will continue to earn revenues. However, the debt began to be downgraded by the credit rating agencies.

A billionaire investor attempted to make a bulk purchase of their stocks, causing the strategies of fund managers to be a tailspin.

Convertible Arbitrage faces the following risks -

1. Credit Risk: Most convertible bonds can be below investment grade or not rated at all, promising extraordinary returns. Hence a significant default risk exists.
2. Interest Rate Risk: Convertible bonds with longer maturity are sensitive to interest rates. While stocks with a short position are a solid hedging strategy, lower hedge ratios may require additional protection.
3. Manager Risk: The manager may incorrectly value a Convertible bond resulting in the arbitrage strategy being questioned. If the valuations are wrong and/or credit risk increases, the value from bond conversion could be reduced/eliminated. Manager risk is also inclusive of the firm's operational risk. The manager's ability to enter/exit a position with minimal market impact will directly impact profitability.
4. Legal Provision & Prospectus Risk: The prospectus provides many potential risks arising in such strategies as early call,special dividends expected, late interest payment in the event of a call, etc. Convertible arbitrageurs can best protect themselves by being aware of the potential pitfalls and adjusting the hedge types to adjust such risks. One also needs to be aware of the legal implications and volatility applicable in the stock and bond markets.
5. Currency Risks: Convertible arbitrage opportunities often cross multiple borders, involving multiple currencies and exposing various positions to currency risks. Arbitrageurs will thus need to employ currency futures or forward contracts to hedge such risks.

Let’s take a practical example of how a convertible arbitrage will work:

The initial price of a convertible bond is $108. The arbitrage manager decides to make an initial cash investment of $202,500 + $877,500 of borrowed funds = Total investment of $1,080,000. In this case, the debt to equity ratio, will be 4.33:1 (Debt being 4.33 times the equity investment amount).

The share price is at 26.625 per share, and the manager shorts 26,000 shares costing $692,250. Also, a Hedge ratio of 75% is to be maintained; therefore, the bond's conversion ratio will be (26,000/ 0.75) = 34,667 shares.

We shall assume a 1-year holding period.

The Total return can be shown with the help of the below table:

Cash Flow in Convertible Arbitrage

Arbitrage Return

The sources of the ROE can be shown with the help of the below table:

In general, convertible arbitrageurs look for convertibles that exhibit the following characteristics:

1. High Volatility – An underlying stock demonstrating above-average volatility is more likely to earn higher profits and adjust the hedge ratio.
2. Low Conversion Premium – A conversion premium is an additional amount paid for convertible security over its conversion value measured in %. In general, a convertible with a conversion premium of 25% and below the same is preferred. A lower conversion premium indicates lower interest rate risk and credit sensitivity, which are more difficult to hedge than equity risk.
3. Low or No Stock dividend on the Underlying shares –  Since the hedge position is short on the underlying shares, any dividend on the stock must be paid to the long stock owner since the strategy's anticipation is the falling share price. Such an instance will create a negative cash flow in the hedge.
4. High Gamma – High gamma means how rapidly the delta changes. Delta is the ratio comparing the change in the price of an underlying asset to the corresponding change in the price of a derivative contract. A convertible with a high gamma offers dynamic hedging opportunities more frequently, thus offering the possibility of higher returns.
5. Under-Valued Convertible – Since the hedged convertible position is long, the arbitrageur will seek issues undervalued or trading at implied volatility levels below average market returns. If the convertible possesses the future of coming back to normal returns, then this will be an appropriate opportunity for the manager to cash in.
6. Liquidity – Highly liquid Issues are preferred by the arbitrageur since they can be used for quickly establishing or closing a position.

There are many convertible arbitrage trades, but some of the common ones are:

• Synthetic Puts: These are highly equity-sensitive trades with "in-the-money" trading conversions of less than 10% premiums. These are convertibles with a high delta, reasonable credit quality, and a solid bond floor. The bond floor is the rate the bonds are offering and is a fixed rate of return (a bond component of convertible security based on its credit quality, expressed in %).
• Gamma Trades: Such trades arise by establishing a delta-neutral or possibly biased position involving convertible security with reasonable credit quality and the simultaneous short sale of the stock. Since such stocks are volatile due to their nature, this strategy requires careful monitoring by dynamically hedging the position, i.e., continuous buying/selling shares of the underlying common stock.
• Vega Trades: "volatility trades" involves establishing a long position in the convertibles and selling appropriately matched call options of the underlying stock trading at high volatility levels. This also requires careful monitoring of the positions involving listed call options as the call option strike price and the expirations must match as close as possible to the terms of the convertible security.
• Cash Flow Trades: Such trades aim to garner maximum cash flows from the arbitrage opportunities. This strategy focuses on convertible securities with a good coupon or dividend income relative to the underlying common stock dividend and conversion premium. It offers profitable trading alternatives where the coupon from the long position or dividend/rebate from the short position offsets the premium paid over time.

Also, look at Top Hedge Fund Strategies

The convertible arbitrage strategy has produced attractive returns over the past two decades, which are not correlated with the individual performance of the bond or the equity market. The deciding factor for the success of such a strategy is the manager risk rather than directional equity or bond market risk. High leverage is a potential risk factor since it can reduce earned returns.

In 2005, investor redemptions significantly impacted the strategy's returns, although the maximum drawdown remains significantly less compared to traditional equity and bond markets. This is in contrast to the good performance of the convertible arbitrage strategy during 2000-02, when the markets were highly volatile due to the dot com crisis. The strategy still appears to be a good portfolio hedge in situations of volatility.

It is essential to continuously monitor the markets and take advantage of situations whereby the bond/stock is undervalued. The bond returns will be fixed, which keeps the manager in a relatively safer position but is required to predict the market volatility also to maximize their returns and extract maximum benefit from simultaneous hold and sell strategies. Such strategies are known to be very beneficial in choppy market conditions since one is required to take advantage of price differences.

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