But it was a false start, and the story of convertibles and 2008 leads us to the opportunity that exists today. 3 major forces, and no shortage of ironies, led to losses of upwards of 50% by convertible-arbitrage funds through October.

1. The Credit Crisis

Convertibles are instruments of corporate credit. When all corporate bonds are losing value, as markets fear decreased liquidity and increased bankruptcy, convertibles will suffer as well.

Remember that you will do no worse than getting back par value for your convertibles as long as the issuing company stays out of bankruptcy. If it cannot, you will only get back your share of the proceeds recovered as the company muddles through the bankruptcy process.

Of course, even more important than true creditworthiness -- whatever that is -- is the perception of creditworthiness. If people believe you are certain to make good on a debt, they will gladly lend you money. As perceptions suffer, reality becomes less relevant, and market prices of debt (including convertible debt) fall.

2. We Invested In Financials, and Those Were the Thanks We Got?

In a year when financial companies have reached out for new capital, the convertible bond market has injected over $30 billion. Some of the companies are still alive—Bank of America (BAC), Citigroup (C) and Fifth Third Bank (FITB), to name several. Others aren’t so fortunate. Fannie Mae (FNM), Wachovia (WB) and National City (NCC) sold convertibles on their way to being taken under. Lehman Brothers needs no further comment.

Now, the convertible market, consisting primarily of hedge funds, was not asking for any special thanks for making these investments. Convertible portfolio managers were trying to make money. Many of them sought to hedge part of their exposure by selling short the companies’ underlying stocks on the premise that the convertibles were a more secure part of the capital structure, offering a better risk/reward profile than the stocks.

Ordinarily, when someone commits a significant amount of money to an enterprise, they receive certain assurances about the integrity of their investment and the underlying rules governing the process. Most of the investors who bought convertibles in financial companies would never have done so had they not been allowed to hedge by shorting the stocks. The few who would have been willing to go unhedged would have demanded far more onerous terms.

But after Lehman went under, regulators decided that short-sellers were really to blame. Without thinking enough about the consequences, they banned, albeit temporarily, the practice of shorting financial stocks. This didn’t fool anybody - after an initial short-covering panic, financial stocks were about 30% lower when the ban was removed compared with when it was instituted. But the prices of financial convertibles, already under pressure from fundamental and market issues, collapsed when it became illegal to hedge them.

In case the reasoning isn’t clear, think about this. Suppose you are deciding between buying 2 houses. They are otherwise identical, but for whatever reason, insurance companies will only write homeowners’ policies on one of them. For which house would you be willing to pay more? Clearly, you would pay more for the house you can insure, and for the other house you would only pay an amount you were prepared to write off entirely.

Anyway, the short-selling ban went into effect when convertibles were already struggling. Then they collapsed, and the headlines started going up about how convertibles were among the worst-performing assets in an awful year. This happened to a strategy (convertible arbitrage) that made its name in the beginning of this decade by providing good returns in a falling stock market.

So, certain investors who had placed money in the strategy for defensive purposes realized they were being severely disappointed and announced they were getting out, leading to selling of all convertibles -- not just financials, which can once again be hedged -- at least for now.