The Rise and Demise of the Convertible Arbitrage Strategy

This article analyzes convertible arbitrage, one of the most successful hedge fund strategies. The aim of the strategy is to exploit underpricing of convertible bonds by taking a long position in a convertible and a short position in the underlying asset. The authors find that convertible bonds are underpriced at the issuance dates; at the same time, short sales of underlying equity increase significantly. Both effects are stronger and more persistent for equity-like convertibles than for debtlike convertibles. Furthermore, short-sale pressures negatively affect stock returns around the announcement and issuance dates of convertibles. All these factors have likely contributed to the shift toward issuing more debtlike convertibles in recent years, which, in turn, has substantially lowered the returns from convertible arbitrage. This article analyzes convertible arbitrage, one of the most successful hedge fund strategies of the last two decades. The aim of the strategy is to exploit the underpricing of convertible bonds by taking a long position in a convertible and a short position in the underlying asset. Convertible arbitrage trades currently represent more than half of the secondary market trades in convertible securities, with hedge funds as the most important player in that market. Moreover, 70–75 percent of primary convertible bond issues are bought by hedge funds. The Convertible Arbitrage Index, which is tracked by Credit Suisse/Tremont, shows that annual returns on convertible arbitrage were, for the most part, above 15 percent in the 1990s and up to 2001. In recent years, however, convertible arbitrage performance has deteriorated. The popular press has proposed various explanations for this decline, including stable equity markets, rising interest rates, withdrawals from funds, increased competition in the hedge fund industry, and lower volatilities in the main capital markets. We demonstrate that the structure of the convertible bond (debt- or equity-like) is an important additional explanation to be considered because the structure affects (1) the degree of underpricing, (2) the “hedging” position in the underlying stock, and (3) the excess returns on the issuer’s equity. We used a sample of convertible bonds in the Canadian market issued between 1998 and 2007. We used the delta measure to make a distinction between debtlike and equity-like convertible bond issues. Using a valuation model, we found the equity-like issues (Δ ≥ 0.50) to be about 27 percent underpriced and the debtlike issues (Δ < 0.50) to be about 7 percent underpriced at the issuance date. Although the underpricing declines somewhat immediately after the issuance, it persists over a long period. Using information on aggregated biweekly short positions on the Toronto Stock Exchange, we examined changes in short positions (interest) around the issuance dates of convertible bonds. We observed a significant increase in the short positions (short interest) of the underlying stocks after the announcement. In the 40 trading days following the announcement, the increases in relative short positions for equity-like issuers are about 15 percentage points higher than those for debtlike issuers. These increased aggregated short positions remain stable for a longer period after the issuance of the convertible. Finally, we show that increases in the short positions negatively affect the excess stock returns of the issuers, particularly during the period between the announcement and the issuance of the convertible. The additional downward pressure exerted on excess returns by the increase in short interest has consequences for both shareholders and debtholders of the issuing company. Clearly, it negatively affects shareholders by destroying shareholder value. Moreover, it also affects debtholders because a lower value of a company’s collateral (proxied by the market value) generally leads to an increase in the credit spread and thus a lower value of current (outstanding) debt claims. To cap these losses in shareholder value, issuers apparently switched to issuing fewer underpriced debtlike convertible bonds, packaged the convertible bond issues together with share repurchases (called a “Happy Meal”), and/or moved out of the convertible bond market altogether. We believe that this shift provides an additional explanation for the lower returns on the convertible arbitrage strategy in recent years.