Understanding Convertible Bond Arbitrage Strategy

Convertible bond arbitraging is an interesting concept. In this blog post, we will dabble in the topic of convertible bond arbitrage to see how one can build a trading strategy around it.

As we know, arbitraging is a process of gaining profit from the price difference in markets due to efficient price discovery mechanism failure. Arbitraging is often market neutral, not affected by the changes in market demand, and hence, involve little to no risk. Convertible bond arbitrage strategy is also based on the same principle. Traders try to make a profit with minimum volatility, regardless of market direction.

What Is A Convertible Bond?  

Convertible bonds are fixed-income debt instruments issued by a company. But these are slightly different from straight bonds. Convertible bonds allow investors to convert a specific number of bonds into common stocks or equity shares. You can think of it like a bag consisting of traditional bonds and equity call options on the underlying stocks. Usually, companies promise to convert these bonds into equities at a 15 to 20 percent discounted rate from the company’s stock price in the market at the time of conversion. Convertible bond arbitrage strategy is formed based on the special characteristic of these bonds.

Convertible bond arbitrage is a way to gain from mispricing between the convertible bond and the underlying asset. The trader tries to generate a consistent return from the arbitraging, avoid market volatility by taking long and short positions in the market simultaneously. Applying to hedge while buying and selling, traders try to gain from market movement.

Traders can gain from exchanging bonds for equities when company stocks price is rising. The deal becomes profitable when stock prices rise above the conversion value of the bond component. When it happens, the bond becomes in-the-money. It depends on the valuation principle of convertible bonds.

The base value of a convertible bond is the ‘investment value.’ It is the present cost of all the future coupon payments and principal repayment. Because of the conversion option, the yield on a convertible bond is usually lower than common bonds. The difference in yields between the two types of bonds is the premium the investor pays for holding a call option on the underlying stock.

The convertible bond price would hit the ‘bond floor’ value when the stock price falls below the conversion price and makes the conversion option nearly worthless. But when stock prices rise, it becomes a profitable strategy.

Let’s summerise our learnings so far.

• Investors can change a portion of convertible bonds into equities
• Because of this feature, convertible bonds carry lower yield, practically a premium paid for holding a call option on underlying stocks, than straight bonds
• Convertible bond arbitrage gains from the difference in pricing between the convertible bonds and the price of the stocks
• It involves taking a long and short position in the market simultaneously – taking a long position with the bonds and shorting in company stocks
• Convertible bond arbitrage strategy helps when the stock price is rising
• The conversion option can lose value when the stock price falls significantly below the conversion price
• Similarly, convertible bonds lose value if company credit credibility deteriorates
• Deep-in-the-money convertible bonds are attractive to investors for income advantages
• Deep-out-of-money convertibles are attractive as fixed-income options

Using Convertible Bond Arbitrage for Profit

Arbitrageurs rely on market mispricing to gain.  If the value of the convertible bond is lower than the price of the underlying, traders will enter a long position with the convertible bonds and sell stocks. Conversely, they will alter their strategy when convertible bonds are overvalued compared to underlying shares. Let’s discuss the components of convertible bonds arbitrage.

Hedging: The hedging ratio is represented by the value of ‘delta’ – share price sensitivity quotient, which determines the price difference of the convertible bond with the price change of the underlying.  However, one should be mindful that the value of delta is variable. It changes with the changes in the stock prices in the market. The change quotient is called ‘gamma.’

Let’s see with a convertible bond arbitrage example. Suppose the convertible bond delta value is 50, which means 50 percent rise or fall in convertible bond price as against share price is acceptable to the trader. As discussed above, the minimum value of a convertible bond is the ‘bond floor’ when the share price falls to zero, when it happens ‘delta’ becomes 100 percent. So, ideally, the value of ‘delta’ never crosses 100 percent. Using ‘gamma,’, traders can adjust the amount of delta.

Strategy: One convertible bond arbitrage strategy involves volatility trading when stock price is close to the convertible bond price. For instance, when delta value is 50, the trader may buy Rs 100 convertible bonds and sell Rs 50 stocks. So, if the stock price rises, his loss from shorting stocks is less than his gain from the convertible. Conversely, if stock prices fall, his profit from shorting surpasses his loss from buying convertibles. In this way, he makes a relatively low-risk profit irrespective of market direction, because arbitrage is direction neutral.

The other strategies involve dealing with deep-in-the-money and deep-out-of-the-money convertible bonds.

Deep-in-the-money convertible bonds are a highly leveraged trade, which allows traders to use the gain from shorting stocks to use buying convertible bonds. More leverage usually results in a higher profit.

Convertible bond trading strategies also involve trading deep-out-of-the-money or ‘busted’ convertible bonds. These bonds have very little delta sensitivity and often mispriced because other hedge funds are selling them. But these bonds offer attractive fixed income options.

Conclusion    

Convertible bond arbitrage strategy may involve one or multiple methods bundled into one. However, one must be mindful that the price of convertible bonds is subject to change with changes in interest rate, cost of the underlying stocks, and the issuer’s credit rating.