Convertible Arbitrage*: Shifting Gears, a new 15 page white paper released by Credit Suisse/Tremont Hedge Fund Index, examines the reasons behind the Convertible Arbitrage meltdown in 2008 and the factors driving the strategy’s recent turnaround.

(* is a market neutral investment strategy that is often associated with hedge funds, involving the long position on a convertible security and a short position in its converting common stock.)

The paper discusses the strategy’s ability to generate positive returns both during the declines in equity markets in January and February, as well as during the global market rallies in March and April.

Convertible Arbitrage went from being one of the worst-performing strategies in the Credit Suisse/Tremont Hedge Fund Index (“Broad Index”) in 2008, to one of the best-performing strategies in the first quarter of this year. Many believe that the fundamental and technical reasons for convertibles’ devaluation in 2008 may correct as credit markets begin to stabilize and if deleveraging continues to abate.

Here are some highlights from the report:

Convertible Arbitrage funds were caught in a “perfect storm” of fundamental and technical difficulties following the fall of Lehman Brothers, resulting in a decline of 25.5% in the period from September 1 to December 31, 2008.

In January, convertible bond yields were atypically more attractive than straight bond yields with similar maturity and seniority in the capital structure.

Although yields have dropped since their highs at the end of 2008, the resurgence of new issuances as well as continued cheapening of the asset class points to Convertible Arbitrage as a strategy that may continue to rebound in 2009 if conditions in the credit markets continue to improve.

Volatility trading of the strategy was curtailed during the large declines in 4Q 2008 and early 2009, but may come back later in the year if equity markets stabilize, albeit with a reduction in the use of leverage.

Convertible Arbitrage registered one of the best performances in the Broad Index for 1Q 2009, returning 7.7%.

And in summary, as a result of the dramatic market events in the last four months of 2008, convertible bond valuations have dropped, possibly creating investment opportunities on both absolute and relative bases.

Factors to consider are:

— Attractive yield levels have persisted through the first quarter of 2009 while credits spreads have widened as many investors were forced to delever

— Equity volatility may remain high in 2009, which could make the convertible bonds an attractive way to gain exposure to stocks

— For equity crossover investors, convertibles have been trading in some instances for small premiums above their conversion value, providing for some a yield-generating equity substitute that has seniority in the capital structure to common equity

— On the credit side, many single name convertible bonds have been in the position of trading at higher yields than straight debt from the same issuers with similar maturities and seniority in the capital structure, thereby providing the equity option at no cost (with some even trading below their bond floor)

So in summary, volatility trading, usually an important aspect of the Convertible Arbitrage strategy, has been curtailed due to the reduction in the use of leverage, the low level of new issuances at the start of 2009, and the weakness of the equity markets in January and February, while the credit play has garnered more attention due to the overall appreciation in the convertible bond market.

This has resulted in a shift in focus for many arbitrageurs, as they take advantage of opportunities on the long side of the credit market, tactically resorting to hedges to contain certain risks. With the fundamental and technical problems that impaired the strategy’s performance in September and October’s environment showing signs of abating, Convertible Arbitrage could be poised for a rebound over the next 12-24 months, although Credit Suisse/Tremont believes there may be some bumps along the way.

Alex Akesson
Editor for HedgeCo.net
alex@hedgeco.net