Convertible bond trading strategies

One convertible bond arbitrage strategy is volatility trading, which is commonly attempted with convertible bonds that are "at-the-money" - when the underlying.
Table of contents

Arbitrage — Volatility Arbitrage Vol Arb Traditionally the strategy looks to identify mispricing of volatility: this can be mispricing of either implied volatility or realised volatility. Opportunistic arbitrage strategies typically have the flexibility to trade across multiple areas, but tend to specialise in a combination of volatility trading, convertible bonds and capital structure arbitrage trades. But they may also focus on other niche areas in order to capitalise upon perceived mis-pricing.

The narrow arbitrage focus is why they are better considered as part of arbitrage, rather than in the broader multi-strategy classification. Credit — Credit Credit Typically focusing upon investments in higher yielding but still performing non investment grade securities, primarily corporate — and sometimes sovereign — debt. The strategy is typically expressed with a net long bias.

Returns are generated from a blend of coupon income and capital appreciation due to spread tightening or widening on shorts. Credit — Distressed Distressed Strategy typically invests in non-investment grade corporate — and sometimes sovereign — debt, which is frequently stressed e.


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Time horizon is typically longer dated. Note, different funds use different methodologies, e. The distinguishing characteristic is that such funds are typically very low net at all times, but some may run with varying degrees of factor or industry exposure, while others may have more stringent risk parameters around such exposures. Event Driven Event Driven Broad strategy category covering funds that invest in securities of companies facing announced and anticipated corporate events. Event Driven — Activist Activist Activist hedge funds invest in companies that they feel are undervalued and the managers then attempt to drive the value creation process by influencing corporate management to undertake initiatives that they feel will benefit shareholders.

convertible bond arbitrage volatility trading

Funds typically own large stakes in the companies they invest in as investors need to be a large enough shareholder to influence management. Event Driven — Merger Arbitrage Merger Strategy typically involves taking positions in the securities of a company being acquired in a merger or acquisition. Primary risk is when deals break, which can lead to asymmetric losses to the downside. Funds will typically trade cash deals and also share-for-share deals, where the fund will short the securities they expect to receive upon deal closure locking in the deal spread.

Event Driven — Multi-Strategy Event Multi Whilst these are multi-strategy funds, they are characterised by their overwhelming focus on the broad event-driven space and therefore placed in their own category. These funds tend to also be more value and soft catalyst oriented. Long Biased Long Biased Long only or overwhelmingly long-biased strategies. Covers multiple asset classes. Such funds still have a hedge-fund structure.

Such strategies typically hold investment grade debt. Long Biased — Diversified Growth Diversified Growth A hedge fund where the majority of the capital is deployed in strategies within the long-biased categories. Long Biased — Commodities Long Commods Funds that take long positions across the commodity complex e. The manager may specialises in one or more of these sub-sectors.

Macro Macro Macro funds take positions can be either directional or relative-value in currencies, bonds, equities and commodities, based on fundamental and qualitative judgements.

Convertible arbitrage - Wikipedia

Relative valuations of financial instruments within or between asset classes can also play a role or be the dominant part in the investment process. Primary areas of focus are the liquid instruments of G10 countries, although they may also include emerging markets. Funds are typically looking to profit from arbitrage, mean-reversion or positive carry.

Most managers incorporate some use of leverage as an integral part of the strategy.

Convertible Bond Question Analysis (SIE + Series 6/7/65/66/CFP)

Macro — Commodities Commods These funds are primarily focused on trading commodity futures and options from both the long and short side. Convertible bond arbitrage is typically a delta-neutral strategy in which the investor purchases a convertible bond and simultaneously sells short the underlying stock in an amount equivalent to the theoretical equity delta of the bond calculated using a convertible bond pricing model.

The strategy was originally conceived to exploit mispricing between the implied volatility of the convertible arbitrage position and the listed equity options, or historical realised volatility. In practice, a convertible arbitrage position is truly dynamic in that a number of different exposures can be replicated depending on where the underlying equity trades relative to the conversion price call option strike of the bond. At lower conversion values, the position exhibits more bond-like qualities, with higher credit sensitivity.

Conversely, at higher conversion values, positions have more equity option-like characteristics and higher equity price volatility sensitivity.


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In addition, managers today may overlay various hedging or directional strategies, including: interest-rate hedges; credit hedges credit default swap or straight bond ; selling the equivalent listed call option to capture a volatility differential ; and adjusting the delta hedge to take more or less equity exposure. Three factors have contributed to the decline in convertible bond arbitrage in the past decade, in our view: a reduction in leverage; continual decline of a hedged implementation; and decreasing primary issuance.

In , the leverage applied to the long side of convertible arbitrage positions approached eight times underlying capital Figure 3. Given the delta-neutral arbitrage implementation, short stock positions were also proportionally inflated. When credit facilities from banks were unceremoniously terminated, calamity ensued.

Convertible Arbitrage Definition

Bonds traded below their conversion value, while prime brokers called for liquidation of client accounts. Fast forward to and long side leverage is down substantially to roughly two to three times underlying capital, with the size of the short stock position therefore being proportionally reduced.


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Third, the rate of primary convertible issuance has been declining over the past 10 years. By and large, most of the decline can be attributed to issuers opting for high-yield debt in lieu of convertibles; high-yield and leveraged loan markets have grown significantly since , while the convertible market stagnated Figure 5. A number of factors can be attributed to the deterioration in convertible issuance, including: the diminished coupon advantage of convertibles in a zero-rate world; low implied volatility level higher volatility allow issuers to command greater premiums ; and the ceaseless passive and active strategy demand for vanilla fixed income products over the past decade.

This year through 9 September, issuance at USD Note: values to 31 July. The continuation of healthy issuance is the first reason we believe investors should consider convertible bond arbitrage. Issuance this year has promoted a steady turnover of names as holders rotate into new paper and create technical trading opportunities. Additionally, new issue pricing has been reasonably attractive this year, in our view, creating incremental investment returns for buyers. While this still holds to an extent, the predominance of long-only funds in the asset class today has created numerous eddies in the broader current.

Essentially, long-only stock picking and index benchmarking behavior has greatly increased dispersion in theoretical value, whereas traditionally the cheapness of a security was highly correlated to the cheapness of the overall asset class. Managers who simply chase the cheapness cycle may be overlooking many promising investment opportunities Figures 7, 8.

Defensive Convertibles

Thirdly, and more importantly, the current volatile environment is favorable for convertible arbitrage investing. While buyout firm Silver Lake capitalized on a surge in AMC Entertainment, one of the stocks at the epicenter of the retail frenzy linked to a convertible bond, others have also seen their bonds gain.

All three stocks were pushed higher in the retail buying rush. He noted that not all stocks that rose last week are linked to convertible bonds, which allow investors to gain from dramatic jumps in share prices but also pay a coupon like a traditional bond.