Convertible Arbitrage Runs Into The Buffers

by Carla Johnson, Investors Offshore, London

30 April 2002

According to a Tass Research report, 'convertible arbitrage' hedge funds attracted more than US$7bn in 2001, more than any other hedge fund sector. But the success of the convertible arbitrage strategy in 2001 may be difficult for the funds to replicate in subsequent years, given reduced volatility in stock prices.

At its simplest, convertible arbitrage strategy players buy a bond convertible into equity and sell short the underlying shares, thus creating a hedged bet on the volatility of the shares. The volatility required to break even on new bond issues last year was 28%; but this year with higher pricing the volatility required is 32%. In fact, volatility has fallen this year, not least because of the weight of convertible holdings by hedge funds which will be sold into any rise in the underlying stock.

It's not rocket science, but for many investors it's beyond their comfort zone, and those who rushed into the winning technique last year may be regretting their move. According to CSFB Tremont, convertible arbitrage yielded negative results in February and March, not least because of the closure of Lipper Convertibles during March.

In fact, investors who pile out now may be ill-advised. Managers have become more sophisticated, and convertible issuance remains strong. On the other hand, companies are pricing their issues more intelligently, having learnt not to offer cheap pickings to the arbs.

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