Benefiting from four decades of experience of the financial markets, Philippe Jabre is an experienced wealth manager who serves as CIO and CEO of Jabre Capital Partners. This article will look at convertible arbitrage hedge funds, a relative value strategy implemented by firms such as Citadel, Two Sigma and AQR, among others.
A convertible bond is a hybrid instrument with elements of both equity and debt. Some groups that trade convertible bonds also incorporate elements of investment banking and sales and trading.
Convertible bonds are often priced inefficiently relative to the underlying stock’s price. To capitalise on price differentials, the investor relies on a convertible bond arbitrage strategy. If a convertible bond is undervalued or cheap relative to the underlying stock, they will take a long position in the convertible bond while simultaneously taking a short position in the stock. Should the stock price fall, they will profit from the short position as their short stock position neutralises potential downside price moves in the convertible bond, enabling the arbitrageur to capture the convertible bond yield.
If stock prices rise, on the other hand, the bonds can be converted into stock to be sold at the market value, providing the arbitrageur with a profit from the long position to compensate for any losses in the short position.
Essentially, in convertible arbitrage strategies, long convertible bond positions are paired with short stock positions in equity of the same company, effectively creating a hedged pair. In addition to pursuing returns via long convertible bond exposure, they are designed to benefit from additional return sources associated with the use of position-level, short stock hedges.
For instance, the strategy may generate additional revenue from short sale proceeds associated with position-level company stock hedges. Also known as ‘short rebate’, cash generated by selling short the equity underlying the convertible sits with the prime broker, earning the overnight rate – thereby supplementing the income received from the bond’s coupon.
Convertible arbitrage centres around using hedge fund profits based on market volatility and price discrepancies between the convertible bond and the underlying stock, with the fund exploiting changes in credit quality, interest rates and volatility to make money while minimising overall market risk. Although there may be exceptions for certain markets and companies, convertible arbitrage strategies generally do not include convertible preferred stock issuances.
An investor using a long-short equity strategy could either long or short a stock, with their results depending heavily on the direction of the overall stock market. If the market were to go up by 20% after they purchased the stock, the investor would likely make money, as most company stocks have a positive correlation with the overall market. With relative value strategies such as convertible arbitrage, overall market results matter considerably less.
Convertible arbitrage presents a unique fixed income alternative in today’s market environment that is designed to both protect against and benefit from market uncertainty, potentially creating scope for enhanced returns while simultaneously reducing risk as compared to traditional fixed income investments. Convertible arbitrage hedge funds are designed to benefit from market uncertainty, essentially monetising volatility – creating scope for an additional source of returns known as ‘volatility yield’. This revenue may enhance the investor’s return significantly as compared to traditional fixed income investments.
Convertible arbitrage strategies can be used to reduce risk in the overall investment portfolio. Not only can integration of a position-level stock hedge allow for enhanced returns through the generation of volatility yields, but it can also help lower credit risk due to the fact that the short equity position typically provides a significant offset in a default scenario, where the underlying stock would fall to zero.
Providing relevant interest rate risk mitigation – as a convertible arbitrage strategy typically spans less than two years – it is designed to benefit from elevated volatility in markets, with its low correlation with traditional fixed income investment providing meaningful diversification within fixed income portfolios.