Over the past 25 years, convertible arbitrage funds have posted a moderately lower average annualized performance than that of equities at less than half the volatility.
What do convertible arbitrage funds do?
• The convertibles market is fairly small and can be inefficiently priced.
• At issuance, convertibles are typically illiquid and thus often undervalued. Also, their equity option component can be mispriced. Price changes in the convertible and the corresponding stock do not always perfectly offset. This creates arbitrage opportunities that hedge fund managers aim to capture.
• Convertible arbitrageurs typically buy the convertible while simultaneously short-selling the company's stock to make their position less sensitive to stock fluctuations and capitalize on potential mispricing opportunities.
• Equity hedging is a crucial part of the strategy and can even generate trading gains. Given the convertibles-toequity price relationship, hedging can require managers to regularly rebalance their short equity position, a process called delta-rebalancing or delta-hedging.
• Besides equity risk, managers also aim to hedge credit and interest rate risks, notably through portfolio diversification or by using credit derivatives (such as credit default swaps), interest rate futures contracts, or swaps.
•Volatility arbitrageurs (gamma traders) predominantly focus on at-the-money convertibles. Such instruments are very attractive in volatile markets given their high convexity (or high gamma). Managers generate returns by holding the convertible and dynamically delta- rebalancing the equity hedge, with every move of the underlying stock in either direction resulting in a small profit at each rehedging.
• Credit arbitrageurs tend to trade deep out-of-the-money convertibles. Similar to distressed fund managers, they typically trade across the capital structure. Alternatively, they can use the convertible to formulate a view on a potential refinancing or restructuring of the issuer and harvest the high credit spread. Given the near-zero value of the option component of such instruments, returns tend to be directional and are more closely linked to credit risk than equity risk. Managers, however, can use credit derivatives to hedge positions.
Index:
HFRI Convertible Arbitrage Index.
HFRI Fund Weighted Index
Convertible arbitrage in your portfolio
• Over the past 25 years, the correlation of convertible arbitrage funds with traditional assets such as equities and bonds has stood at 0.58 and 0.23, respectively.
• This imperfect correlation enables convertible arbitrageurs to potentially improve the risk-reward of a multi-asset class portfolio.
• Convertible arbitrage strategies can be illiquid, however, given the nature of the underlying. Highly leveraged, they may also suffer substantial drawdown in market crises.
• As with other hedge fund strategies, we only advise an allocation to them within an already well-diversified hedge fund portfolio and would keep the allocation balanced versus other strategies.
Convertible arbitrage and the business cycle
• Convertible arbitrage funds typically post their highest returns during the economic recovery phase. The strategy benefits from the overall credit spread tightening environment that leads to a rebound in convertibles, particularly highly credit-sensitive ones (deep out-of-the-money or distressed). Managers also benefit from attractively priced new issues as access to capital remains stretched for many companies, and convertibles may be the only way to raise cash.
• As the economy moves into more mature stages, convertible arbitrage returns moderate. Volatility declines and stays low, decreasing opportunities for volatility traders (gamma traders). New issues are also somewhat limited owing to cheap and easy access to capital while credit spreads are tight.
• In the recession phase, while greater volatility aids them, convertible arbitrageurs typically suffer significant drawdowns. Sharp credit spread widening, along with illiquid and highly leveraged positions, largely offsets the positive effect from volatility.
What are the risks?
• By design, convertible arbitrageurs are exposed to equity, credit, option, and interest rate risks.
• In addition, convertibles are relatively illiquid. During crises, bid-ask spreads can widen significantly and traders may not be able to sell assets at the desired price. Because of their short equity positions, arbitrageurs also face recall risks and short-selling bans.