Convertible bond arbitrage looks set to revive as volatility creates opportunities

In an uncertain world, convertible bond arbitrage has much to offer in downside protection and potential upside. Greater volatility increases the opportunity set for this strategy to create value.

Having fallen dramatically from grace in 2008, convertible bond arbitrage looks primed to make a comeback as securities cheapen and a change in the investor structure of the asset class creates more dislocations in prices.

Convertible bonds can be converted into equity at a pre-determined date and price that usually constitutes a discount to the market value. When a convertible bond is deep in-the-money (the underlying equity is trading well above the conversion rate), convertibles tend to behave like equities.

However, when they are deeply out-of-the-money as equity markets fall, they behave like credit, offering considerable downside protection because they offer fixed maturities and redemption schedules. Their position in the capital structure of a company is above that of equities and usually in line with senior unsecured debt.

Such bonds demonstrate convex price behaviour and have historically shown less than half the price volatility of equities, producing better risk-weighted returns.

In its most simple form, a convertible bond arbitrage manager would buy the convertible bonds in a company and sell the stock short. This strategy should do well whatever direction equity markets move.

If equities are falling, the fixed income characteristics of the convertible should protect it from a similar scale of decline as the equity. While the attraction of converting the bond disappears, the short equity position should prove beneficial, offering protection from downside risk.

In rising markets the manager should be able to take advantage of the long bond position and convert into stock at a discounted price. The manager can make a significant return by selling a considerable portion of equity short at the higher market price and buying at the lower strike price on the convertible.

If neither equities nor credit are showing much movement, there is a sweet spot in the middle of the curve where managers can take advantage of gamma trading, adjusting their exposure to the market by increasing or decreasing their equity short position based on the probability of the convertible option being exercised.

If the equity price increases and the option looks more likely to be exercised, a gamma trader will sell more stock short in the knowledge he can buy it back at the lower strike price on the strike date. If the equity price falls, the manager can leverage the difference between the two market prices to reduce the short exposure and make a return.

All things to all trades?
Convertible bond arbitrage can “be an all-weather strategy if it is done properly,” says Hedeer El-Showk, risk manager and portfolio manager of $1.4 billion hedge fund Signet’s Ucits fund of hedge funds (FoHF).

However, theory and practice often produce very different results. The impact of factors like liquidity, leverage or unexpected market events can be extreme. In 2005, for example, many arbitrageurs were holding long positions in General Motors convertibles and shorting the stock.

When a large investor, Kirk Kerkorian, tried to purchase GM stock at the same time ratings agencies were downgrading its debt, investors suffered losses on both sides of the trade.

In 2008 convertible bond arbitrage fell dramatically from grace, with the HFRI RV: Fixed Income-Convertible Arbitrage Index recording a loss of 33.73% for the year, the second worst performance of all sub-sectors of the HFRI Fund Weighted Composite Index (down 19.03% that year). “In a liquidity crisis you’re going to get hurt in convertible arbitrage very badly,” notes Sol Waksman, founder of BarclayHedge.

By early 2008 convertible bond arbitrage had become a crowded market and funds were levered by around eight to 10 times. When Lehman Brothers collapsed, it removed not only a significant player in the convertible bond area but also one of the most significant providers of leverage.

The UBS Convertible Bond Global Focus index, which ended 2007 at 190.4 fell 26% by the end of 2008 to 140.44, having reached a bottom on October 27, 2008 of 123.7, 35% below its starting level.

“The poor performance in 2008 was due to concentration, high levels of leverage and the aggressive withdrawal of that leverage by prime brokers as well as the Lehman Brothers event. That put a lot of convertible arbitrage investors off the space,” says Mike Reed (pictured), senior portfolio manager at $40.6 billion BlueBay Asset Management.

Despite this, the strategy bounced back in 2009, returning 60.17% based on the HFRI convertible arbitrage index, the best performing strategy in the HFRI universe by over 28% and more than three times the return of the average fund as measured by the HFRI Fund Weighted Composite Index.

In 2010 convertible arbitrage was the second best performing strategy returning 13.35% versus 10.25% for the composite index.

By 2011 the environment was proving challenging once again due to the ongoing eurozone sovereign debt crisis and a faltering global economic recovery. This resulted in heightened volatility. Convertibles underwent a period of illiquidity and risk aversion, putting pressure on valuations.

The first quarter of 2012 was better as the general market rally benefited most hedge fund strategies. However, by April, as eurozone troubles re-emerged, convertible arbitrage funds were once again in the red, recording losses and under­performing the composite index by 0.7%.

“The general environment for convertibles and all risk assets has deteriorated markedly since the beginning of April,” Reed says. “Credit and equity markets have both performed badly and there has been an element of cheapening of convertibles.” The UBS Convertible Bond Global Focus index fell 5% between April 2 and May 18 ending at 185.42.

Yet, despite April’s wobble for the year to the end of April, the HFRI RV: Fixed Income-Convertible Arbitrage Index was up 5.22%, slightly outperforming the broader market index. Other measures show a similar outperformance.

“In the very recent term it has been an interesting market for the space,” says Ken Heinz, president of Hedge Fund Research. “These strategies are well represented in terms of performance for the year so far.”

“The HFRI Relative Value Arbitrage Index has been positive in 34 of the last 40 months and has been positive every month so far in 2012,” notes Heinz at Hedge Fund Research. “Looking at the last five quarters capital flows have been strongly in favour of arbitrage strategies. Nearly 50% of net capital flows to the hedge fund industry have gone to arbitrage strategies.”

Arbitrage strategies overall have enjoyed around $550 billion inflows over that period, he says, of which around 10%, or $55 billion, has gone to convertible arbitrage specifically.

“Convertible arbitrage assets are at the highest level they have ever been,” Heinz says. Multi-strategy funds have seen the most significant portion of flows, which will also be benefiting convertible arbitrage indirectly.

In the current uncertain environment dominated by political risk, the appeal of a strategy that can offer significant upside and volatility hedging whichever way markets move is clear, while the opportunity set for gamma trading becomes greater. “The probability of exercising the option sets how much you sell short or buy back,” BlueBay’s Reed says. “The more the market goes up and down, the more it is possible to exploit this gamma trade.”

The Federal Reserve has promised to hold interest rates low for a prolonged period, probably up to 2014. The same scenario looks increasingly likely across the globe in the short term. The minutes from May’s Bank of England monetary policy committee meeting show policy makers are leaning increasingly towards another round of quantitative easing. Meanwhile, the ECB is coming under greater pressure to lower interest rates.

With growth slowing in emerging markets, the central scenario for many investors is a continued low interest rate environment in the developing world over the next few years.

Hedging volatility
Convertible arbitrage can also be seen as a way to buy volatility or hedge its effects in other parts of the portfolio. It also acts as a form of downside protection because falling equity markets present an opportunity to benefit from the equity short position inherent in convertible bond arbitrage while also protecting portfolios through convertibles’ fixed-income attributes such as the bond floor and its place in the capital hierarchy.

Even over the longer term, convertible arbitrage appears to have much to offer. Convertible arbitrageurs should also do well as interest rates normalise and risk appetite returns, pushing up equity prices.

“Coming out of this crisis convertibles will be a good place to be so a shrewd convertible arbitrage manager is something to safeguard,” says Signet’s El-Showk.

Historically, convertibles have posted positive returns in years when government bonds have experienced losses. There have been three occasions in the last 20 years (1994, 1999 and 2009) when 10-year US Treasuries have posted losses of around 5%. On average convertible bonds gained 13.8% during those periods according to a BlueBay analysis.

A rise in both interest rates and equity markets tends to push up convertible valuations and also creates favourable conditions for gamma trading. As interest rates increase, convertible arbitrageurs’ scope to benefit from selling stock short also increases. Further gains in stock prices only support this opportunity set further.

The recent cheapening of convertible bonds, as demonstrated by 5% drops in both the UBS Convertible Bond Global Focus and Jefferies Active Convertible indexes between the beginning of April and May 18, has also created a buying opportunity for convertibles, not just because their prices are lower.

When a sharp cheapening occurs, the convexity of the curve for convertibles increases allowing greater scope to exploit the gamma trading opportunities available.

According to Beat Thoma, chief investment officer of Sfr6 billion ($6.2 billion) convertible bond manager Fisch Asset Management, the biggest risk in today’s market is already priced in. So, a Lehman-scale shock is unlikely even if the eurozone collapses.

“Unlike 2008 convertible arbitrage managers are aware of the big risks in Europe,” he says. “Before it happened the Lehman crash wasn’t on the cards. Today the worst case scenario is priced in and a reasonable convertible fund should include protection against a breakdown of the banking system.”

In addition the long-term demand and supply dynamics appear supportive of increased convertible valuations.

On the supply side new issuance of convertibles has fallen as the low interest rate environment makes issuing convertible bonds less attractive versus bank borrowing and straight bonds, particularly for investment-grade names.

This drying-up of the market will result in shrinkage, particularly in Europe and in Asia, where one expert suggested the market could be 25% smaller by year-end.

According to Dealogic figures, global convertible bond issuance has been on a steady decline since the fourth quarter of 2009 having more than halved from $35.6 billion to $15.4 billion in the first quarter this year. Asia-Pacific issuance has fallen 68% over the same period from $12 billion to $3.9 billion while Europe has fallen 30% from $9.1 billion to $6.4 billion.

Global issuance dropped 45% in the first quarter of 2012 while the US was down 72% and Asia recorded a 55% fall. Europe, however, was the exception, recording a 61% increase from $4 billion to $6.4 billion.

Falling issuance should prove supportive of convertible valuations, particularly in investment-grade securities, which have been especially affected but where demand remains strong. “Issuance is shrinking fast on the investment-grade side,” says Aviva Investors’ senior fund manager, global convertibles, Shawn Mato (pictured).

“Investment-grade convertible bond investors therefore have to keep pushing up prices. There is some pretty drastic richness in investment-grade converts. Historically they have always traded dearly, but some well-known names are at extreme levels now,” Mato notes.

Meanwhile, the demand side of the equation continues to look strong. The low-growth, low-inflation environment with its disappointing equity returns and low bond yields is widely expected to ensure credit remains a favoured asset class over the medium term, adding further support to convertible bond prices.

Perhaps more interestingly, the investor landscape for convertibles has also changed markedly since 2008, creating significant demand and valuation support for these securities.

“In 2008 75% of the convertible bond market was held in some levered form,” says Mato. “Today its structure is very different with 60%-75% of the market owned by outright (or long) convertible bond holders. That makes the market less efficient because there is a greater disparity between the owners of those securities.”

Bigger discrepancies between cheap and expensive securities and the lack of issuance means greater opportunity for arbitrageurs. “In the last two to three years we have seen a big rise in the convertible long-only base,” explains BlueBay’s Reed.

“What you need as an arbitrage investor is a set of investors taking different investment decision on different bases. Long-only investors might be looking to exploit equity views, for example, rather than the cheapness of the convertible. That means a divergence in the cheapness across the universe, which affords arbitrage managers a richer set of opportunities,” he adds.

It also opens the door for an increase in reverse strategies where arbitrage investors short expensive convertibles and go long the underlying equity, known in the industry as ‘Chinese-ing’.

“Especially in the US we have seen a number of investment-grade bonds trading at a level that is around 3%-4% rich,” Aviva’s Mato says, “so there is an opportunity for this kind of strategy, especially in the investment-grade market.”

Decreased competition
As well as supportive supply/demand dynamics for the asset class, convertible arbitrage, like all relative value strategies, is sensitive to the level of competition chasing similar strategies and this space has seen a significant decrease in competition in recent years. The closure of banks’ proprietary trading desks has had a big effect.

“Convertible arbitrage is a very traditional prop-desk type of strategy. Banks are now getting out of proprietary trading so there is less competition to buy the stocks that someone in this space would find attractive. There is more room to make money,” notes BarclayHedge’s Waksman.

Despite its resurgence in performance, convertible bond arbitrage is the ugly duckling of strategies as its reputation remains tarred. “The strategy is still lost and forgotten. Performance grated on a lot of people in 2008, which left a bad taste in investors’ mouths. That reverberates down the road so this strategy is still lost,” says Aviva’s Mato.

Arbitrage in general is seeing a massive surge in interest as performance remains consistent across the broad relative value space and investors seek yield and market neutral strategies that offer downside protection and diversification into areas with low or negative correlation to equities.

Rising interest rates should also bode well for issuance. “As rates increase, we should see quite a quick pick-up in convertible bond issuance,” Fisch’s Thoma says. “If we see a solution, or partial solution, in Europe for Greece and Spain and economic confidence increases, then we should see much higher interest rates and subsequent issuance of convertible bonds.”

In a world dominated by uncertainty, low interest rates and volatility, convertible bond arbitrage appears to have much to offer in terms of downside protection and potential upside as many of the big risks are already priced in and greater volatility increases the opportunity set for this strategy to create value.

Even so, convertible bond arbitrage is still regarded with suspicion despite strong supply/demand fundamentals and decreased competition.

“There are far fewer players in this space today so the opportunity set is spread over fewer competitors,” notes BlueBay’s Reed. “The reason convertible arbitrageurs can do well is because the investor base is dominated by long-only players driven by a different decision framework, which creates considerable dislocations in valuations. That allows convertible arbitrage managers to be risk neutral and profitable,” he concludes.