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Convertible Arbitrage Carnage Continues



Editor's Note: Minyanville is a community of people who share an interest of fiscal literacy. As perspective is an important aspect of our daily routine, we share this exchange with hopes that it adds balance to your process.

Prof. Succo,

As you are likely aware, the carnage, though out of the headlines for now, has not abated in convert arb land. In less than a week we have had two takeovers which have crushed the convert arb community.

Last week, it was Ivax (IVX) taken out by Teva Pharma (TEVA), this week's much worse hit is RBK. As you know, these guys are long convert bonds, which have massive premium contraction on the take out, and short stock, which rallies to the take out price. So they get the double whammy of losing on their bond positions (that is to say, losing on a relative basis as the bond price is up with the common), and get smoked on their short stock position.

Now, to keep things balanced (and as you and I have spoken about in the past), as an outright convertible investor, I am still making nice money as I am long bonds, which are up with the common (though not up as much as we would have hoped). So for outright convertible investors, this is still a nice, positive event.

The point is, the pain continues for the convert arb community. Outright convert investors continue to do very well on an absolute basis and particularly well on a risk-adjusted basis.

Hope this finds you well!

Minyan Brian


It is nice to hear from you. We estimate that convertible bond arbitrage hedge funds will lose about $34 million from the Reebok (RBK) transaction. This amounts to about 10 basis points, which is not much.

But as you are aware there is a disturbing trend.

We only have positions in convertible bonds that have protection for such events, although that is not a sure thing. For example we've seen bonds issued through a large broker dealer which were represented as being protected in a cash takeover, but in reality were not (you actually had to go to the debenture to find this out). There is a lot of garbage flying around in this product.

Convertible arbitrage is a dangerous game, as you point out, because of the numerous nuances and non-conformity. Quite simply, you have to be on your toes and a non-conformist to properly assess value and risk. It is ironic that so many corporations raise capital through convertible bonds (that they know are being sold to such hedge funds), yet seem to somewhere along the line complete a transaction that severely hurts these hedge funds.

I don't blame the corporations. I blame hedge funds that buy them willy nilly without really thinking through the implications. We buy them strategically and opportunistically, not wholesale, just like any other investment. When you buy them outright, it seems you are doing the same, just willing to take the stock risk.

This is a good lesson. The term "investment strategies" is a misnomer. There is no "strategy" that makes money in all markets; there is no strategy that can ignore risk. Every security, every investment, must be weighed for value against risk. It is unknown risk that is inexcusable: risks must be quantified and accepted.

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