Convertible Bond Arbitrage

What Is Convertible Bond Arbitrage?

Convertible bond arbitrage refers to a trading strategy that exploits the price difference between a convertible bond and its underlying equity. It aims to generate profits from possible price divergences irrespective of market conditions while minimizing the volatility risk. It has the characteristics of stocks plus bonds.

It gives a fixed interest rate, including conversion to a fixed quantity of shares. Traders and hedge funds seek to utilize the mispricing avenues to gain profits by long positions of convertible bonds and short positions in the underlying security. Investors get the opportunity to gain from equity markets and fixed income together.

• Convertible bond arbitrage exploits price differences between convertible bonds and their underlying equities to generate profits in all market conditions while minimizing volatility risk.
• The requirements are in-depth knowledge of bond and stock prices, strong risk management skills, sufficient capital, comprehensive market data etc.
• It has limits like transaction costs, borrowing costs, liquidity risk, market risk, credit risk, competition, regulatory risk, and technology risk. Arbitrageurs face liquidity risk, among others.
• To be profitable, one must - identify mispriced bonds, analyze conversion terms, hedge stock, hold a long position, monitor market conditions, manage risk, and monitor arbitrage opportunities.

How Does Convertible Bond Arbitrage Strategy Work?

Convertible bond arbitrage means a sophisticated investment strategy seeking profits from mispricing between underlying security and convertible bonds. It has been seen as a market-neutral strategy that works without accounting for the market conditions or the direction in which it sways. The convertible bond arbitrageurs take long positions for convertible bonds and short positions for the underlying equities. It is done to hedge against the risk of equity price changes.

Moreover, with rising equity prices, the arbitrageur loses money on their short positions and profits from their long position in the convertible bond. Contrarywise, if there is a fall in equity prices, arbitrageur makes money from their short position while losing money on their long position on convertible bond. Let us understand the mechanism of working the bond arbitrage.

• Pricing of convertible bonds: First, traders have to price the bonds, which are affected by the conversion price, the interest rate, the underlying equity's price, and the issuer's credit quality.
• Valuation dynamics: A convertible bond becomes valuable if its underlying equity price rises beyond its conversion prices. Hence, investors can change it into a greater number of shares of equity. If the equity price decreases below the conversion price, the convertible bond becomes less valuable. As a result, investors will hold on to the bond to receive fixed interest payments.
• Exploiting mispricing: As soon as mispricing arises between underlying entities and their bond, investors take a long position for the bond and a short position for the equity. It helps them hedge against price fluctuations and get profit.
• Risk management: As the investor can simultaneously hold on to long plus short positions, they manage risk effectively.
• Profit generation: Investors wait until the convertible bond attains the equity's intrinsic value, leading to profit generation.

Requirements

Investors and traders need specialized tools and requirements to succeed in complex convertible bond arbitrage investment strategies. For the same, listed below are some of the requirements:

• Access to assets: Arbitrageurs should have access to the underlying asset plus convertible bond. One must have a brokerage account or a member of specialized convertible bond arbitrage funds.
• In-depth knowledge: Arbitrageurs need in-depth knowledge of bond and stock prices and the factors affecting their prices, like the issuer's credit quality, conversion price, underlying equity price, and interest rates.
• Risk management skills: A strong skillset in effective risk management to navigate risks such as market, credit, and interest rate risks must be present.
• Sufficient capital: Sufficient funds and capital are required to execute the strategies effectively. Otherwise, investors may not be able to fund their positions.
• Market data: Comprehensive and timely market data has to be there with the arbitrageurs. Then, only well-judged and informed decisions can be taken by them to make gains at minimum risk.
• Fast-paced trading: Convertible bond arbitrage requires a fast-paced market, able to perform trades speedily and efficiently for capitalizing on mispricing avenues.
• Advanced modeling: Sophisticated computer modeling techniques are required to gauge mispricing opportunities. The advanced modeling tool is beneficial to traders.
• Networking: A network of contacts must be with the arbitrageurs to get valuable information and insights about underlying equities and convertible bonds.
• Financial acumen: Strong fundamentals of the financial industry and successful investing are required to attain success.

Examples

Let us understand the topic using a couple of examples.        

Example #1

The Bloomberg Convertible Bond Arbitrage Hedge Fund Index (BHCBA) monitors hedge funds using convertible bond arbitrage strategies. Established in 2001, it comprises diverse hedge funds employing various convertible bond arbitrage tactics. One common approach it deploys is to buy undervalued convertible bonds compared to their underlying stocks. Simultaneously, the investor shorts the stock and converts the bond into shares when the stock's price increases, profiting from the price difference.

As a result, the BHCBA performance is discussed here. Since its inception in 2001, BHCBA has averaged 5.2% annual returns, outperforming the S&P 500 in 12 to 18 years. As of October 2, 2023, BHCBA is up 1.84% for the year. Benefits include exposure to convertible bonds, diversification, and historical outperformance. Risks encompass management fees, complexity, and volatility. Hence, it is important to consider these factors before investing.

Example #2

Let us illustrate convertible bond arbitrage using the information from the provided data. Suppose Company XYZ issues a convertible bond with a face value of $1,000 that can be converted into 100 shares of XYZ stock. The bond's market price is $1,050. Simultaneously, XYZ's stock is trading at $11 per share. Then, a trader makes a lossless profit using the below bond arbitrage.

An investor, Ramen, buys the convertible bond for $1,050. Simultaneously, the investor sells short 100 shares of XYZ stock for $1,100, betting that the stock price will decline. As a result, a delta-neutral position is created. It means the investor has balanced the exposure to the underlying stock's price movements.

Hence, the investor benefits from discrepancies in pricing between the bond and the stock. If the stock price falls, the short position in the stock profits, while the convertible bond may remain stable or even appreciate, leading to overall gains. 

Limits

One needs to know its limits to gain more from the convertible bond. Below listed are limits for the same:

• Transaction costs: It involves huge transaction costs as it has to adopt complex strategies while implementing many trades.
• Borrowing costs: For financing their positions, traders borrow money, so they have to pay huge interest, leading to large borrowing costs.
• Liquidity risk: Arbitrageurs find it difficult to exit their positions from adverse markets as these bonds are hard to convert into liquid assets.
• Market risk: Arbitrageurs witness the loss of their money in the market as the convertible bonds and their underlying stock prices fluctuate with the market.
• Credit risk: The issuer of convertible bonds may default on their credit obligations. As a result, the arbitrageurs may lose money if the issuer defaults on their obligations.
• Competition: As it is an old technique in the market, many arbitrageurs compete with each other to benefit from price mismatch. Thus, many arbitrageurs fail to gain from trading these bonds.
• Regulatory risk: Regulators regulate these bonds strictly, so any change on their part may make it hard for arbitrageurs to execute their strategies for profits.
• Technology risk: The arbitrage of convertible bonds relies fully on computer modeling technology. Any flaw in software or hardware while using these models may lead to huge losses for the arbitrageurs.

How To Profit from It?

A large number of arbitrageurs are into making profits from convertible bonds. Hence, one must know how to make a profit from it using below steps:

• Identify Mispriced Convertible Bonds: One must identify those bonds with lower value than their underlying stocks.
• Analyze Conversion Terms: Arbitrageurs must assess the bond's conversion terms, like conversion period, ratio, and price. Only then can they assess their losses and gains by conversion.
• Hedge the Stock: A short position of the underlying security must be taken to mitigate equity risk and safeguard the position from decreasing stock price.
• Take Long Position in Convertible Bond: A long position of bonds must be taken as it makes it valuable in relation to the underlying stock.
• Monitor Market Conditions: One must be abreast of all the latest developments, events or news concerning the market and underlying security for gauging any adverse effect on it. It aids in making informed and informed profitable decisions by the arbitrageur.
• Monitor Arbitrage Opportunities: Continuous monitoring must be done on the price differences between a convertible bond and its underlying asset. If the mispricing between the two disappears or narrows, then positions must be closed to realize profits.

Hence, convertible bond arbitrage hedge funds use a variety of strategies to profit from mispricing between convertible bonds and their underlying equities. Convertible bond arbitrage is a complex strategy requiring a deep understanding of convertible bond pricing and market factors. Convertible bond arbitrage ETF is an exchange-traded fund that tracks an index of convertible bonds. 

Frequently Asked Questions (FAQs)

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