The Case for Convertibles

by Dion Friedland, Chairman, Magnum Funds

Fund manager Mikhail Filimonov isn’t taking any chances, or any large ones anyway, with investments like that of his nine-year-old daughter’s college savings. Instead, Filimonov has adopted a low-risk, high-reward approach for his Alexandra Global Investment Fund, so-named for his daughter. Buying convertible bonds and simultaneously selling short the underlying stock, Filimonov positions his investments to be neutrally hedged — in other words, immune to market fluctuations. If a stock price falls, the investment is protected — and often enhanced — by the short position. No matter the stock price, the investment generates profits from interest on the bond and short sale proceeds.

Filimonov’s approach is called convertible bond arbitrage, one of many hedging strategies found in the hedge fund universe. Hedge funds refer to funds that can use one or more alternative investment strategies. Popularly perceived to be risky due to over-publicized losses in global macro funds in recent years, hedge funds, in fact, by their very definition seek to protect their investments by hedging against the downside. True, not all hedge funds hedge, but many do, and one of the most successful of these techniques is convertible bond arbitrage.

The term arbitrage refers to the trading strategy of identifying assets which are not efficiently priced by the market in comparison to prices of other related assets. In the case of convertible bonds, it works like this: Take a 5% convertible bond maturing in one year at $1,000, exchangeable into 100 shares of non-dividend-paying common stock currently trading at $10 per share. An arbitrage strategy might hedge against this long convertible bond with a short position of 50 shares of underlying common stock at $10 per share. Pricing inefficiencies between these two related securities, as we’ll see, allow for profits both when the stock price rises and falls. Adding to gains on the downside is the fact that convertible bonds can only fall in value as low as their investment value — the value of the same company bond if were it were not convertible. In this case, let’s say the investment value is $920.

An investment position such as this would likely have the following return dynamics:

Return When No Change in Stock Price:

Interest payments on $1,000 convertible bond (5%)

Interest earned on $500 short sale proceeds (5%)

Fees paid to lender of common stock (0.25% per annum)