What is convertible bond arbitrage?
Convertible bond arbitrage sounds like a mouthful, but it’s actually a pretty straightforward idea once you break it down. Let’s say you’re an investor or hedge fund manager looking to make some money in the financial markets. One strategy you might use is called convertible bond arbitrage.
Here’s how it works: you buy something called a convertible bond. A bond is basically like a loan – when you buy a bond, you’re lending money to a company or government, and they promise to pay you back later with interest. What makes a convertible bond special is that it can be “converted” into stock in the company if certain things happen.
The three levers
Now, the price of a convertible bond is influenced by three main things:
- The price of the company’s stock
- The company’s credit spread (basically how risky it is to lend them money)
- Interest rates in the broader market
As an arbitrageur doing convertible bond arbitrage, your goal is to “hedge” or get rid of the risk associated with two of those three things. That way, you’re only exposed to the risk of one factor, which you think you can predict or have an edge on.
Hedging the risks
Let’s say you think a company’s stock price is going to go up, but you’re worried that rising interest rates might hurt your bond investment. To do convertible bond arbitrage, you could buy the convertible bond and at the same time “short” or bet against the company’s regular non-convertible bonds. That way, if interest rates go up, the loss on your convertible bond will be cancelled out by your short position on the regular bonds. You’ve hedged away the interest rate risk.
Locking in profits
Now let’s talk about that credit spread – the risk that the company might not be able to pay back its bonds. To hedge that, you could buy some credit default swaps – basically insurance policies that pay out if the company defaults. By owning the CDS, you’ve taken credit risk off the table too.
So now you’re just left with exposure to the company’s stock price. If it goes up like you predicted, the value of your convertible bond will increase and you’ll make money. You’ve eliminated the other risks through your hedges. That’s convertible bond arbitrage in action.
Who does convertible bond arbitrage?
Convertible bond arbitrage is a popular strategy among hedge funds and other sophisticated investors. It’s not the kind of thing an average Joe investor would do in their spare time – it requires a lot of knowledge, skill, and access to various financial instruments and markets.
Hedge funds love this kind of strategy because when it works, it can provide solid returns that aren’t too correlated with the broader stock or bond markets. It’s a way to diversify and generate “alpha” or excess returns.
The risk of convertible bond arbitrage
Of course, like all investments and trades, convertible bond arbitrage comes with risks. The biggest one is that your hedges might not work perfectly. Your short bond position might not fully eliminate interest rate risk. Your CDS might not fully hedge the credit risk. Stuff happens in markets that can cause these complex trades to go haywire.
There’s also a lot of competition in this space. Convertible bond arbitrage has been around for a while and a lot of smart people are trying to do it. That can make it hard to consistently make money, especially in calmer markets where there are fewer opportunities.
Variations of convertible bond arbitrage
Over time, convertible bond arbitrageurs have developed different variations and enhancements to the basic strategy. Some traders might only hedge one of the three risks, not two. Some might not hedge at all and just make a directional bet on the stock or bond.
Others might add leverage to juice their returns, borrowing money to buy more bonds than they could otherwise afford. Some funds use fancy computer models and algorithms to constantly optimize their hedges and find small opportunities.
The evolving convertible bond market
The convertible bond market itself is always evolving too. Companies are constantly issuing new converts with different features and terms. The size and liquidity of the market changes over time with economic conditions.
Regulatory changes can also have a big impact. After the 2008 financial crisis, new rules made it harder for banks to trade and hold convertible bonds, which reduced liquidity and forced some arbitrage funds to adapt.
Convertible bond arbitrage and market efficiency
In a sense, convertible bond arbitrageurs are acting as the grease that helps the market function smoothly. By constantly hunting for mispricing and hedging away risks, they help keep prices in line with fundamentals.
If a company’s convertible bonds are too cheap relative to the stock and straight bonds, arbitrageurs will swoop in and buy them until the prices adjust. If they’re too expensive, they’ll sell or short them. This buying and selling pressure helps keep the convertible bond price in that Goldilocks zone.
The double-edged sword
But some critics argue that arbitrageurs can also destabilize markets at times. If a bunch of hedge funds are all doing similar trades and one of them has to suddenly unwind and sell, it can lead to a domino effect of selling that causes prices to plummet more than they should.
We saw this during the quant meltdown of August 2007, when a number of big quant hedge funds had to unwind similar positions at the same time, leading to big losses. Some of these were convertible bond arbitrage positions.
