Convertible arbitrage is a trading strategy that typically involves taking a long position (buy) in a convertible security and a short position (sell) in the underlying common stock. The goal of the convertible arbitrage strategy is to capitalize on pricing inefficiencies between the convertible and the stock. Convertible arbitrage is a long-short strategy that has been employed by hedge funds. However, convertible arbitrage is not without risks, and multiple steps are involved in implementing the strategy.

Key Takeaways

  • Convertible arbitrage involves taking a long position (buy) in a convertible security and a short position (sell) in the underlying common stock.
  • If the stock price declined, the trader would benefit from the short stock position while the convertible bond would decline only slightly.
  • Ideally, the falling stock price would create a smaller loss on the convertible security than the gain in the short-equity position.

Understanding Convertible Arbitrage

A convertible security is an investment that has the option to be modified or changed into another type of investment. Convertible securities are often bonds that have the option to be converted into stock. A bond is a debt instrument that companies issue to investors to raise funds whereby the bond pays interest over the life of the security. Convertible bonds also have a specific amount that it is converted into as well as at a pre-determined time.

Convertible securities are hybrid securities with features of two investments. A convertible bond, for example, has features of a bond, such as an interest rate, and features of a stock since it can be converted into stock and sold at the prevailing market price. However, convertible bonds typically offer a lower yield or interest rate and typical bonds. The reason for the lower yield is that the investor has the option to either hold the bond until maturity or convert it into stock when the company's stock price rises to a pre-specified level.

The Long-Short Strategy

Long-short investment strategies are not new in the financial markets. Typically, the strategy involves a long position where an investor buys a stock believing that the price will rise in value while simultaneously taking a short position in a stock that's expected to decrease in value.

A short position is when an investor sells a security in the open market and receives the funds upfront from selling the security. The investor has the intention of buying back the security at a later date when the price has fallen. Ideally, the investor would be selling the shares at a higher price and then buying back the shares later at a lower price. The net difference between the proceeds received from selling the stock initially and the cost of buying back at the lower price would be the profit. 

Of course, a short position can go wrong when the stock being shorted increases in price well beyond the initial selling price. As a result, the investor would have to offset the short position by buying the stock at a higher price than the price that it was originally sold for when the short position was established. Instead of using two equity positions, convertible arbitrage uses a convertible security and the common stock of the same company. 

Convertible Arbitrage Strategy

The rationale behind a convertible arbitrage strategy is that it enables gains to be made with a lower degree of risk. The investor would own the convertible security and have a short position or a sell position on the stock of the same company. Risk can be reduced under the strategy because the convertible bond typically has less risk of volatility or wild fluctuations in price as compared to stocks. 

If the stock's price declined, the arbitrage trader would benefit from the short position in the stock, while the convertible bond or debenture would typically experience less downside risk. Ideally, a fall in the stock price would create a smaller loss on the convertible security than the gain in the short-equity position.

Conversely, if the stock price rises, the loss on the short stock position would be capped or limited, because the gain on the convertible would partly offset it. If the stock trades sideways, the convertible bond would likely pay a steady interest rate that could offset the costs of holding the short stock position.

The convertible arbitrage strategy is not a commonly-used strategy in the present-day world, where algorithmic and program trading has proliferated to prevent such arbitrage opportunities.

Risks to a Convertible Arbitrage Strategy

A convertible arbitrage strategy is not bullet-proof. In some instances, it can go awry if the convertible security declines in price but the underlying stock rises, creating a loss in the short stock position.

Market Timing

Timing the convertible arbitrage strategy can be quite challenging. The bond might have a waiting period before investors are allowed to convert it to stock. In other words, if an investor initiated a short position in the stock and was holding the security, the bond might not be convertible until the specified time period had elapsed. During the waiting period, the investor would be at risk. If the stock rose before the security could be converted to stock, there could be a loss on the position.

Credit Downgrades

Also, a company could experience financial difficulty leading to a downgrade in the company's debt, meaning the bond's credit rating would decline. Debt instruments are rated by rating agencies, such as Standard & Poor's, to help investors assess the risk of investing in corporate and government bonds.

Market Inefficiencies

When investors short a stock, they typically believe the stock is overvalued, or the price has been run up too far. As a result, when the investor initiates the short position on the stock, a risk with the strategy is that the convertible security might also rise in price. In other words, the convertible security could–along with the stock price–be overvalued, meaning that it could be selling at a premium to the market. There's no guarantee that the convertible security would be selling at a fair price or that the market would be efficiently pricing the security at its fair value.

Exogenous Events

Another risk to convertible arbitrage is that exogenous events can impact the profitability of the strategy. For example, a company could experience a decline in stock price, creating a gain in the short position, but also experience a credit downgrade whereby the convertible security declines in price. During the 2008 financial crisis, for example, many stocks experienced price declines while their corporate debt was being downgraded by credit rating agencies. 

Example of Convertible Arbitrage

As an example, let's say a stock is trading at a price of $10.10 in the current market. It also has a convertible issue with a face value of $100 and is convertible into 10 shares at a conversion price of $10; the security continues to trade at par ($100).

Assuming there are no barriers to conversion, an arbitrageur would buy the convertible and simultaneously short the stock, for risk-less profits (excluding transaction costs) of $1 per $100 face value of the convertible.

The arbitrageur would receive $10.10 for each share sold short and would be able to cover the short position right away by converting the convertible security into 10 shares at $10 each.

As a result, the total gain per $100 face value of the convertible would be: ($10.10 – $10.00) x 10 shares = $1 in profit. Although one dollar may not appear to be a significant gain, a 1% risk-less profit on $100 million amounts to $1 million in profit.