Convertible Bond Arbitrage

The convertible bond market in Asia is not so much in a perfect storm but in a perfect calm; new issues have dried up and there is an overall lack of liquidity in the convertible bond market. However, given the horrible state of the equity markets, it's a good sign that companies aren't issuing converts. If they were, it would be a sign of desperation; such as AMP's recent issue in Australia. Yet, this lack of liquidity and new issuance combined with distressed share prices has implications for some strategies.

The typical convertible bond arbitrage strategy is to go long on the convertible bond, to short the equity and put the proceeds on deposit and then arbitrage the mis-pricing of the equity option imbedded in the convertible. Convertible bond arbitrage funds are usually highly leveraged.

However, this strategy in Asia has been superseded by a more distressed debt approach because equity prices have fallen so far. The convertibles are currently so far out of the money that they are trading as pure debt instruments. Equity share prices would have to dramatically recover before the convertibles could have any likelihood of being converted, so currently they have little or no option value.

This means that the nature of the trade has changed. Some investors are now buying convertible bonds to hold them for yield and then insuring the risk of the company going bust by entering into a default swap. Typically this involves paying a premium to a financial intermediary or insurance company. This premium guarantees over the life of the bond or over a period of say, 5 years, that if there is a default by the company, the holder gets paid in full. So the investment strategy is now to hold the bond for the yield over its lifetime with full protection if the company goes bust in the meantime.

This strategy is fine as long as there is no pressure for funds to liquidate their convertible bond portfolios. Holding on to the bond until maturity or bankruptcy is a strategy that works. The risk is the in-between case where investors in convertible arbitrage hedge funds decide to pull out of the strategy. Because of the extreme lack of liquidity in the market for convertible bonds, turning positions into cash to pay the redemptions could be a problem. There is the scenario of the vicious circle -falling NAV leads to redemptions, redemptions mean selling into a market where there will have to be discounts to get bids, falling prices then lead to falling NAVs which in turn…

The situation in Asia is particularly interesting because overall the credit market is less sophisticated and lacks depth. Arguably in western markets if debt began being mis-priced due to forced selling in one instrument it would be picked up and re-packaged in another form. This also means that price of default swaps - which are necessary to provide the credit hedge - could escalate the cutting of margins on the trade.

In Asia a lot of the convertible bonds are USD instruments issued by companies, which trade in non-USD currencies. A strengthening of the USD (which is a possibility in the perfect storm scenario) would exacerbate the problem. The outlook for new issues of convertibles, which are necessary to provide liquidity, is dire. Because of the length of the bear market the pool of convertibles available tends towards stale, illiquid, and out-of-the-money instruments. Hedge funds are the holders of the majority of outstanding convertible bonds throughout the world, and the liquidity in the secondary market is at its lowest point ever

What does this mean for hedge funds using convertible arbitrage strategies? Convertible bond arbitrage puts people long on volatility. In markets like this that's a good thing. However, it also puts them long on credit, which has been a good thing up until now but is something that could reverse itself. As the markets have dropped the funds have become less long on volatility and more long on credit.

It is therefore critical to look at the quality of the bond portfolio and the liquidity of the underlying positions. The level of cash in the portfolio is also important. The length of the redemption notice period will give protection against forced selling into a bad market. Valuations of holdings become more difficult and judgemental the more illiquid the underlying market becomes.