34.1 EVOLUTION OF THE CONVERTIBLE ARBITRAGE STRATEGY

Convertible arbitrage is a classic arbitrage strategy that attempts to exploit inefficiencies in the pricing of convertible bonds relative to their underlying stocks. Initially, convertible arbitrage started as a niche business for dedicated proprietary trading desks in large investment banks. Convertible arbitrageurs typically bought cheap convertible bonds and hedged their market risk by selling short the underlying stocks. Subsequently, thanks to the development of sophisticated option pricing models and the availability of credit derivatives, the strategy expanded to include volatility and credit trading elements. As of year-end 2011, Hedge Fund Research (HFR) reports that dedicated convertible arbitrage funds represent less than 3% of the assets managed by hedge funds. Though quite small in comparison to, say, equity long/short, convertible arbitrage shares important features common to a variety of hedge fund strategies and serves as a valuable example.

In its simplest form, the convertible arbitrage strategy involves purchasing convertible bonds and hedging away various risks associated with the instrument, including equity risk, credit risk, and interest rate risk. The ultimate objective is to isolate underpriced options embedded in convertible bonds. Naturally, the question arises as to why corporations should issue underpriced securities. The answer is simple. In addition to raising capital through the issuance of debt, corporations have the potential to raise capital through the issuance of equity. When a corporation issues convertible bonds, convertible arbitrage managers will short the underlying stock, effectively increasing the supply of shares. If the firm performs well and the convertibles expire in-the-money, the increase in the number of shares will become permanent as the convertibles are exchanged for shares. In this scenario, the firm has effectively raised capital by issuing new equity without incurring the administrative costs associated with a straight equity issue. For firms that typically issue convertible bonds, raising capital through straight bonds or equity may prove to be too expensive. For example, the straight bonds might have to carry a very high coupon, which would negatively affect the cash flow of the firm. Though raising capital through equity alone may not have the same negative cash flow impact, the size of the issue might have to be so large that it would dilute the ownership of current shareholders. In short, convertible arbitrage managers provide a service to issuing corporations and get paid for this service. This provides a partial economic explanation for the potential source of alpha found within the convertible arbitrage strategy.

This raises yet another question: Why wouldn't other investors step in to purchase these underpriced securities? The answer lies in the very nature of convertible bonds. They are neither stocks nor bonds but a hybrid of the two. As such, many traditional money managers do not have a natural place in their portfolio for them. Furthermore, taking advantage of the mispricing of convertible securities requires managers to hedge a number of risks. This requires special skills, which traditional money managers may not possess. In addition, the investment strategy may not fall within the mandate of many traditional investment managers.