Convertible arbitrage is a type ofequity long-shortinvesting strategy often used by hedge funds.
An equity long-short strategy is an investing strategy which involves taking long positions in stocks that are expected to increase in value and short positions in stocks that are expected to decrease in value.
Instead of purchasing and shorting stocks, however, convertible arbitrage takes a long position in, or purchases, convertible securities. It simultaneously takes a short position in, or sells, the same companys common stock.
To understand how that works, it is important to know what convertible securities are. A convertible security is a security that can be converted into another security at a pre-determined time and a pre-determined price. In most cases, the term applies to a bond that can be converted into a stock. Convertible bonds are considered neither bonds nor stocks, but hybrid securities with features of both. They may have a lower yield than other bonds, but this is usually balanced by the fact that they can be converted into stock at what is usually a discount to the stocks market value. In fact, buying the convertible bond places the investor in a position to hold the bond as-is, or to convert it to stock if he or she anticipates that the stocks price will rise.
The idea behind convertible arbitrage is that a companys convertible bonds are sometimes priced inefficiently relative to the companys stock. Convertible arbitrage attempts to profit from this pricing error.
To illustrate how convertible arbitrage works, a hedge fund using convertible arbitrage will buy a companys convertible bonds at the same time as it shorts the companys stock. If the companys stock price falls, the hedge fund will benefit from its short position; it is also likely that the companys convertible bonds will decline less than its stock, because they are protected by their value as fixed-income instruments. On the other hand, if the companys stock price rises, the hedge fund can convert its convertible bonds into stock and sell that stock at market value, thereby benefiting from its long position, and ideally, compensating for any losses on its short position.
Convertible arbitrage is not without risks. First, it is trickier than it sounds. Because one generally must hold convertible bonds for a specified amount of time before they can be converted into stock, it is important for the convertible arbitrageur to evaluate the market carefully and determine in advance if market conditions will coincide with the time frame in which conversion is permitted.
Additionally, convertible arbitrageurs can fall victim to unpredictable events. One example is the market crash of 1987, when many convertible bonds declined more than the stocks into which they were convertible, for various reasons which are not totally understood even today. A more recent example occurred in 2005, when many arbitrageurs had long positions in General Motors (GM) convertible bonds and short positions in GM stock. They suffered losses when a billionaire investor tried to buy GM stock at the same time its debt was being downgraded by credit-ratings agencies.
Finally, convertible arbitrage has become increasingly popular in recent years as investors have sought alternative investment options. That has reduced the effectiveness of the strategy.
In summary, convertible arbitrage, like other long-short strategies, may help increase returns in difficult market environments, but it isnt without risks. As a result, investors considering a hedge fund that uses convertible arbitrage may want to carefully evaluate whether the potential return is balanced by the potential risks.