How It Works
In the
A long position is taken in the convertible bond and a short position in the underlying stock. In this way they try to exploit the mispricing in convertible bonds. Convertible arbitrage trades currently represent more than half of the secondary market trading in convertible securities with hedge funds as the most important player in this market.
They have a preference for underlying stocks that pay low or no dividends, that are undervalued, liquid and that can be easily be sold short.
Convertibles are bonds which can convert into stock at a certain price at a certain point in the future. Investors get the certainty of bond coupon payments, plus an option to buy stock at a given price if the stock has risen.
The Definition
Convertible Arbitrage involves purchasing a portfolio of convertible securities, generally convertible bonds, and hedging a portion of the equity risk by selling short the underlying common stock. Certain managers may also seek to hedge interest rate exposure under some circumstances. Most managers employ some degree of leverage, ranging from zero to 6:1. The equity hedge ratio may range from 30 to 100 percent. The average grade of bond in a typical portfolio is BB-, with individual ratings ranging from AA to CCC. However, as the default risk of the company is hedged by shorting the underlying common stock, the risk is considerably better than the rating of the unhedged bond indicates.
What It Does
We observe significant increases in the short positions of the underlying stocks after the announcement of a convertible bond issue. In the 30 trading days following the announcement of the issue, the increases in relative short positions for equity-like issuers are about 25 percentage points higher than for debt-like issuers.
When the stock price approaches the conversion price, the delta of a convertible bond increases; since the bond becomes more equity-like (i.e. the price of the bond becomes more sensitive to the changes in the value of the underlying equity). This means that more stocks need to be shorted in order to maintain the neutral hedge ratio, which is defined as a product of the conversion ratio and delta. The opposite holds if the stock price goes down.
However, we do not find evidence that these average declines vary systematically with short-selling activity (i.e., there is no evidence that arbitrage is what is driving the declines).
Moreover, we do not find similar results for the control firms. The cross-sectional results presented in the previous sections indicate that the convertible bond arbitrage strategy has a significant impact on liquidity of the market for the underlying stock.
How Long It Lasts
Callable bonds often have call protection periods, generally greater than six months. The exercise of a conversion option leads to the creation of new shares. Long term strategies will hold the bond for several years while collecting interest.
How It’s Abused (from Felix Salmon)
In the case of the Vivendi offering, the share price fell an eye-popping 14% in the three days before issue, so it’s hardly surprising that the regulators investigated. However, even after paying the fines, they’re likely to come out ahead on this deal.
Hedge Fund Research, Inc.
http://www.hedgefundresearch.com/pdf/HFR_Strategy_Definitions.pdf
By Igor Loncarski, Jenke ter Horst, Chris Veld
By
July 2007
http://www.fdic.gov/bank/analytical/cfr/choi_getmansky_tookes.pdf
Hedge Funds’ Insider Trading in Convertible Bonds
By Felix Salmon
http://www.portfolio.com/views/blogs/market-movers/2007/06/22/hedge-funds-insider-trading-in-convertible-bonds
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