Convertible Bonds: An Investor's Best Friend, Part 2
All the upside, but better downside protection.
Hedge-Fund Leverage and Forced Selling
The investors who made money from convertibles in 2000-2002 were not the unhedged investors so desperately needed in today's market. They were hedge funds who bought convertibles, shorted stocks and profited when the convertibles fell much less than the stocks did. So the hedge funds posted great performance in a bad market, drew in a lot of new money and became the predominant buyers of convertibles.
Here's how hedge funds made money in convertible arbitrage. The simplest, and most important, detail is that convertibles (which the hedge funds owned) lost much less than their underlying stocks (which the hedge funds had sold short).
But the strategy also depended on leverage. The reason is that, like most arbitrage strategies, convertible arbitrage depended on exploiting relatively small price differences between similar financial instruments.
Let's say you can buy a stock, ZYX, in the United States for $100 and sell the same stock in Canada for $105 (American) at the same time. The only catch is that you have to wait a year to deliver the stock you bought in the United States to the person in Canada to whom you sold it.
So, you pay $100 today to get $105 in a year. You make 5%, risk-free (we'll assume the Canadian buyer is absolutely creditworthy). In normal times, it's hard to attract a lot of investors advertising this kind of return. (I repeat, in normal times). But what if you can borrow $300 at 3% and use it to do the same trade?
Now you are making a $5 profit on your own $100, plus a $2 profit on each $100 you borrow: $5 on the trade less the $3 you pay in interest on the borrowed money. So your total profit is $11 on your $100 of capital. The 11% return, seemingly risk-free, will start to get people's attention.
Convertible arbitrage is, or was, somewhat like this. It wasn't this simple, and it certainly wasn't risk-free. But the idea was the same: buy something in a cheap form (the convertible), sell it in a more expensive one (the stock), and wait for the valuations to converge, doing it all the while with lots of borrowed money.
The trades worked even better in the aftermath of the dot-com bubble. Many companies issued convertibles when their stocks had triple-digit P/E ratios. Once they gave any indication that earnings growth might slow, the stocks lost the lion's share of their value, but the companies were never in any danger of bankruptcy. So the convertible bonds only fell to the level they warranted as fixed-income instruments with definite maturities, even as many of the stocks fell 70, 80 or 90%.
But here's the problem. Even ignoring credit concerns -- though it's hard to ignore them these days -- let's just go back to the American/Canadian stock trade. Suppose that a big Canadian investor has been buying up the local market, including ZYX. This investor has driven the Canadian price up from $105 to $110. But the American market hasn't changed. What's worse, the banks that loaned you the money to implement your strategy see what's going on, and they are getting nervous.
"Relax," you plead with them: "In less than a year, I'll be able to deliver my ZYX stock against my sale, and then I can pay you back when I get paid."
The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.
Copyright 2011 Minyanville Media, Inc. All Rights Reserved.
Daily Recap Newsletter