An insight into how convertible arbitrage works and what lies behind its extraordinary risk adjusted return statistics
Heard of an asset class that earns current income, has a principal guarantee and participates in the upside of equity markets. Sounds too good to be true. Add to it the hedging skills of arbitrageurs and what you have is convertible arbitrage. Convertible arbitrage is a relative-value strategy that straddles two key markets, equities and bonds. You might recall that relative-value strategies are market neutral and focus on exploiting opportunities between 'related' securities. Convertible arbitrage qualifies, as the instruments - convertible bonds and equity - share a common issuer. The strategy attracts strong institutional inflows due to its desirable risk-return characteristics and unique diversification benefits.
Then and now
Contrary to popular perception, convertible arbitrage has been around since the early 1920s. The strategy itself is pretty simple, go long (buy) on the convertible bond and go short (sell borrowed shares) on the related equity. Back then, it was more of an art than science as approximations were used to determine the risks and hedge ratios. However, the cornerstone of the strategy remained the same - to exploit the pricing inefficiencies between the convertible bond and underlying stock. Nowadays, managers have the advantage of quantitative models backed by computing power to value the components of convertibles and the embedded options values in much greater detail. Risks are also better-understood and quantified. The range of opportunities is much wider than before as issuers of convertibles cater to the insatiable demand from convertible managers. Availability of derivatives to hedge specific risks as well as enhanced global information flows have contributed to the evolution of the strategy. Convertible managers use a range of hybrid instruments such as warrants, preferred and zero coupons. However, it would help if one understood the nature of convertible bonds to appreciate the key aspects of this strategy.
Part bond, part equity
A convertible bond can be described as a regular corporate bond with the added feature of being optionally convertible into a fixed number of shares of common stock of the issuer. The number of shares or the conversion ratio, the conversion price and the conversion period are pre-specified. Therefore, convertible bonds have dual or hybrid characteristics - the principal protection of a conventional bond including regular interest income and the possible upside from equity participation. Sub-investment grade issuers in particular, find it cost-effective to raise funds through convertible bond issues as the equity conversion option makes it attractive to investors.
Convertible bond prices are a function of three values. The 'investment value' or 'straight bond value', which is the value of a conventional bond of similar characteristics. The 'conversion value' or the value of the number of shares it can be converted into multiplied by the prevailing share price. And thirdly, the 'option value' or the value of a having the right but not the obligation to convert into equity shares at a pre-specified price.
Predictable relationships
A convertible bond cannot theoretically trade below its straight bond value which forms a floor. Even if the equity value falls below the conversion price making the equity conversion option worthless, the company is bound to pay interest and principal. Then comes the conversion value, which represents only an upside as there is no obligation to convert if the market price is below the conversion price. If the equity price is lower than conversion price, the straight bond value dominates market price. On the other hand, if equity prices are high, the conversion value dominates. Barring exceptional events, the convertible bond can never trade below the straight bond or conversion values. In fact, the right to convert is an optional right and commands a premium by itself. Therefore, the convertible bond might trade at a slight premium to the straight bond and conversion value. Take for example, ABC Corporation's convertible bonds that are maturing in 2010. The face value of the bond is US$1,000 which can be converted into 50 ABC equity shares. The conversion price, therefore, works out to US$20 per share. If the ABC shares trade at US$24 per share the conversion value of the bond is US$1,250 and the convertible price will tend to reflect this. However, at below US$20, the convertible price will tend closer to the straight bond value.
Delta hedging
A typical convertible arbitrage trade involves buying the convertible bond and shorting the equity shares of the same issuer. The number of shares to go short is a function of sensitivity of convertible bond prices to movements in the share price of the company. The short position offsets the convertible bond's exposure to the share price and is known as 'delta hedging'. Usually, the sensitivity of the convertible bond is lesser than one. Assume that in the example of ABC Corporation, the convertible moves by 50 per cent of the move in the underlying equity shares. This means the hedge fund manager will go short in ten shares of ABC to hedge his convertible bond position.
But there is another important fallout of delta hedging. And that is volatility. Delta hedging is effective only for small movements in the share prices. If the share price falls or rises steeply, delta hedging breaks up. Ironically, this is to the advantage of the hedge fund manager. For instance, if in our example, the share price falls steeply, say by 30 per cent, the convertible bond is supposed to fall by 15 per cent (going by the 50 per cent sensitivity of the bond to the underlying equity). Instead in actual practice, the bond value falls by much lesser due to the peculiar non-linear relationship between convertibles and the underlying equity. The hedge fund manager gains from the short position due to the fall in share prices and this more than offsets the losses from the long convertible position.
The imperfection of the delta hedge works in the other direction as well. If the share prices move up, the conversion value and the option value dominate the pricing of the convertible bond, magnifying the up-move in share price on the convertible bond. While the short position might lose money, the long convertible position gains by much more, offsetting the losses from the short position. Thus a convertible manager can make money in a falling and rising market.
Beyond volatility driven returns
In a way, most convertible managers are long volatility and gain from it irrespective of market direction. The profit payoffs from convertible arbitrage resemble the payoffs from conventional derivatives like calls and puts. Therefore, a manager with a bearish outlook can structure his position to behave like a put option, which gains if prices fall. A manager with a bullish outlook can structure payoffs resembling a call option.
Volatility driven returns are only part of the overall returns. Most conservative hedge fund managers view the cash flows from the position as the prime driver of returns. Going long on the convertible and short on the equity generates what is known as 'static returns'. These returns are the current yield on the bond plus the short interest rebate, net of dividend expenses on short position. The volatility component and other opportunistic trading strategies such as gamma trading are called the 'trading returns'. The last component of returns is 'leveraging return' - net of interest costs. Most convertible managers, depending on their risk appetite and position characteristics, use leverage to magnify returns.
Risks can be hedged, but at a price
Despite the promise of returns irrespective of market direction, convertible arbitrage has its share of risks - the basic risks of bonds including the risk of interest rate movements, default risk and spread expansion. At a systemic level, any loss of liquidity in bond markets can cause spreads to widen. On the equity side, a big risk is the ability to sustain a short position in the shares due to sharp in case of a sharp upward movement. Leverage adds to the risk by magnifying returns and adding to the interest rate sensitivity of the entire position. All of these risks can be hedged, but at a price. Skillful use of derivatives such as shorting treasury futures to hedge against interest rate risks or using credit default swaps to reduce the credit risk are among the many options available to a convertible manager. To sum up, it is up to the manager to decide the risks that need to be hedged and those that can be left open. Not surprisingly, there are significant gaps between performances of top quartile managers vis--vis the bottom quartile, irrespective of overall market dynamics.
Convertible arbitrage has been through a tough 2004 due to a combination of factors. Rising interest rates forced managers to reduce leverage. Also the cost of interest rate hedges ate into wafer thin returns and cut off managers from the mini-bond rallies that sprung up now and then. Volatility levels were also at record lows, cutting off another source of returns for managers. This meant that most managers got into a conservative mode, de-leveraging themselves and positioning themselves for increased volatility and idiosyncratic opportunities if any. Some detractors point to the growing lack of opportunities in this space, especially keeping in mind the flood of funds this strategy attracted over the past five years. Leaving aside immediate circumstances, one cannot ignore convertible arbitrage given its extraordinary risk-reward payoffs and the ability of managers to evolve and uncover newer sources of returns.
The author is VP - Asset Management, FINCORP Tel: +968 7716655 Email: anand@fincorp.org
(The views expressed in this article are those of the author only.)
Anand Subramaniam
© businesstoday 2004
