A Trade for our Times
In an environment dominated by uncertainty and low rates one strategy offers investors the potential ability to capture yield and potential upside while also minimising downside risk. In fact, increasing market volatility increases the opportunity for capturing value.
Convertible Bond Arbitrage involves buying the convertible bonds of a company while simultaneously selling short that company’s stock.
The investor essentially sells the stock today receiving cash proceeds hoping to buy it back in the future at a lower price if equity markets fall. These proceeds sit in a rebate account but in the current low rate environment earn little return. However if rates rise, the rebate account earns a greater amount of interest offering an additional source of return to the convertible arb investor.
The strategy should do well as a fixed income strategy regardless of which ways markets move. If the stock is declining, the short sold position will increase in value. With the short sold position neutralising the decline in the value of the convertible bond, investors can still harvest yield from the convertible bond trade. The same can work in reverse if the stock appreciates. This illustrates the “market neutral” nature of the convertible arbitrage strategy, hence offering less risk than investing in traditional stocks and bonds (ie fully hedged).
A study by Palmer Square Capital Management in 2012[i] highlighted the low correlation and volatility of convertible arbitrage strategies relative to traditional stocks and bonds. The study examined the risk/return profile of the HFRI convertible arbitrage index against equity and bond indices between 1990 and 2011. The convertible arbitrage strategy generated higher yields than both equity and bond indices over the period in addition to significantly lower standard deviation than equities (and only slightly higher than the bond index).
Pension funds sometimes use convertible arbitrage strategies as part of their fixed income strategy to provide diversification while also generating yield1. Investors often don’t realise how exposed their portfolios are to capital loss in the event of rising interest rates.
The US Federal Reserve has raised interest rates three times in 2017[ii]and forecast rates to rise another 25 basis points before year end[iii]. Central banks around the world are looking to reign in quantitative easing measures that have held rates abnormally low (though labour market weakness remains an issue). As discussed, convertible arb strategies can provide yield but also downside protection in the event of rising interest rates.
[i] Long, D.(2012) Convertible Bond Arbitrage, Palmer Square Capital Management LLC
[ii] Chau, D.(2017) US Federal Reserve raises rates again, while ASX looks set to drop on wobbly lead overnight, ABC News, 15 June
[iii] Source: US Federal Reserve Bank via TradingEconomics.com