I am wondering if an individual investor can engage in convertible bonds arbitrage or if there are barriers of entry impeaching one to do so (such access to greeks data, material needed, software, database, or else).

I will greatly appreciate your insights.

you will have to get familiar with the greek term “rho”. It tells you the price sensitivity to changes in interest rates.

Another important use of CB arbitrage are carry trades. If you setup the trade as discussed above, and strip the credit (by means of asset swaps) you actually use very little of your original cash. Therefore you can put on a large degree of leverage, and your original coupon becomes massive if compared to your original cash investment. Obviously, the borrow costs, and dividend costs will also be leveraged.

Its tricky. As you said above, there if no free lunch, but if you are willing to put on the risk, then the rewards could follow.

Thanks.

Yes, your comments help. If I understand you correctly, the hedge [shorting the stock] is inordinately profitable only if the conversion privilege [Call option] is mispriced – in your explanation, actual volatility exceeds the level that is priced into the CB.

Anytime any security is mispriced, there is an opportunity for inordinate returns. But, I presume that the Call options on almost all CBs are not mispriced; I presume that they are properly priced.

Accordingly, I still have the question as to why most CB investors do, in fact, short the stock.

Thanks for your help.

I will try to give you the explanation you are looking for as to why they do it:

When you buy a CB you pay an implied level of future volatility in the stock. You hedge the delta (say 50% to start off with). At this point you are market neutral as far as the stock movement is concerned. If the stock falls the delta sensitivity of the CB will be lower, but you still have your original 50% hedge on, so you will be making more money on the hedge than the money you are loosing on the CB. At this point the delta may be 45% so in order to rebalance your positon you buy back 5% hedge. If the stock goes back up, you are short 45% hedge but the CB will be back to a 50% delta, so you will make more money on the CB than you lose on the hedge.

In essence you are long volatility, because you have to continue to do this buy low sell high trades (delta hedging) in order to make the same money you will lose on time value (conversion premium). So in order to have many of these stock movements to rebalance, and therefore to make profits, your stock has to trade at a realised volatility higher than the implied volatility you payed on day one. If future realised volatility is lower, you WILL lose money.

Not to mention interest rate exposure, and above all, credit risk exposure…

Does that help?

In Case 3, there is a statement that, if the stock price falls, the price of the convertible bond [CB] remains constant at $1,000 because that remains the intrinsic value of the bond portion of the CB. But, the price of the CB WOULD FALL because 5% is NOT the rate that would exist on a straight [non-convertible] bond; $1,000 is NOT the instrinsic value of the bond. The rate on the CB is 5% only because it carries the conversion privilege. The rate on a straight bond would be higher than 5%.

Indeed Comment 11 acknowledges that the rate on a CB is lower than the rate on a straight bond.

The price of a CB consists of the price of a straight bond plus the price of the conversion privilege [similar to a Call Option]. As the price of the stock falls from $20 to $15, the value of the conversion privilege [Call Option] falls and so does the value of the CB. In Case 3, the decrease in the value of the conversion privilege would exactly offset the other gains so that the net inordinate gain (above the 5% interest) would equal zero. [The math here is pretty complex and there is an assumption that the stock hedge was appropriate (dependent on the "delta" of the stock) and that everything occurred instantaneously.]

It is true that CB investors usually hedge by shorting the stock. However, I have never seen an adequate explanation of why they do it – unless, of course, they believe that the conversion privilege is mispriced.

Remember Friedman’s dictum – There is no such thing as a free lunch.

If the proposed scheme worked, we would all be rich.

Have you done a lot of these? How has it actually worked for you?

I can give some perspective here. I have a Certifieed Hedge Fund Specialist designation and I can tell you that was by far the most interesting investing program I’ve taken.

Convertible bond arbitrage is one of the most consistent hedge fund strategies. The convertible bond hedge fund index almost never has a negative year, but has had several small negative years this decade. So it is a good strategy.

Hedge funds buy the same stocks and bonds, but differ from mutual funds by their strategy. There are 14 categories of hedge fund strategies, most of which are designed to get equity returns or more without all the ups and downs.

Convertible arbitrage is the 2nd most consistent category (after equity market neutral). The word in the industry for both convertible arbitrage and merger arbitrage is “Picking up dimes in front of steam rollers.”

This is because it almost always produces a small profit (if done right), but occassionally backfires very badly.

There is not a lot done in Canada, due to lack of supply of convertible bonds.

The pros usually buy where there is a mispricing between the convertible and stock, or where they anticipate some specific event. They usually leverage 2-10 times (since there is not much cash outlay when you buy the bond and short the stock). They also often buy various options to protect against possible general market risks.

Ed

[...] Journey has an excellent two part article on how convertible bond arbitrage works. Here’s part II. Now you have no [...]

Any change in market conditions that affects the price the buyer of the bond pays is usually either absorbed (in the case of a loss) or welcomed (in the case of a gain) by the intermediary.

With respect to the second part of your question you actually have it backwards. The more enticing a bond is (i.e. the more bells and whistles in favour of the investor) the cheaper it is – and that is built into a LOWER coupon rate. For example: if you have a straight bond, a callable bond (the ISSUER can force you to give it up before maturity), and a retractable bond (the INVESTOR can force the issuer to take back the bond before maturity) all from the same issuer with the same term then the Callable Bond will have the highest coupon rate (i.e. 5.5%) the straigh bond might have 5% and the retracable bond will have 4.5%.

In this case, since the investor has the added sweetener of being able to participate in the appreciation of the common shares ONLY if the shares go up, but will otherwise have the floor of the bond, the coupon rate would normally be lower.

But the par and maturity price is always set.

Let me know if that makes sense and thanks for the questions everybody! :) Keep ‘em coming…

So in this case you have earned 18.0% for the year because the share price went up.

FT: Can you replace Case 2’s text with this comment’s text? :)

nobleea: You are quite right – I had made mention of this to FT last week when I submitted the article – but perhaps I didn’t hit the send button on my email – I will amend in a following comment in the next few minutes.

FT: NO – it is not a rule of thumb to short half the long position. For this particular case to yield positive results in all three scenarios it is possible to do so because there is a floor value of the convertible bond. The upside of the shares is theoretically extremely high so if they go up A LOT, then you will still make money because you lose roughly half as much on the short. The downside is limited due to the floor of the bond. You can only lose so much on the convertible bond, but your gain on the short is limited too, just not as much as your loss is limited. Does that make sense? The takeaway is that this particular arbitrage strategy can yield positive results due to the floor value of the bond.

Mike