In order to understand how to execute a convertible arbitrage trade, we must first need to learn what convertible bonds are and since last week we discuss the municipal bond arbitrage strategy ; learning this new arbitrage method is going to be easier.

What is a Convertible Bond?

Bonds are debt obligations to credit issuers. They are nothing more than commercial loan used by the company as a way to raise investment capital. Like any other type of debt, bonds are subject to terms and conditions; like interest rate (coupon) and loan period (maturity). However, the structure of a convertible bond is a bit more complicated since it includes the possibility of equity ownership. Convertible bonds give investors the option to redeem share of the company by exchanging the debt for equity at a predetermined value (conversion ratio). These kinds of bonds are great investment vehicles, because they offer income, upside potential, and risk management. But their most unique quality is their versatility to create exotic investment strategies such as convertible bond arbitrage.

What is Convertible Bond Arbitrage?

Within convertible arbitrage there are many strategies that may focus on the volatility or credit risk of a security. But the most popular and profitable, and the one we individual arbitrageurs (retail investors) can replicate is the Cash and Carry Trade .

Under this technique traders will buy the convertible bond of an overvalue security while at the same time selling short the stock. Because of the equity call option characteristic of the convertible bond the position becomes naturally hedge; in terms creating a market neutral trade. Placing this kind of trade is not easy and it requires some serious mathematical skills and sophisticated trading tools in order to avoid execution errors. Remember that all arbitrage tactics require simultaneous execution.

How to Arbitrage Convertibles Bonds

Not to worry in today’s case study, I am going to share with you an example and a trading tool that will help you calculate all the pertinent metrics and risk required to arbitrage a convertible bond by following this equation and steps:

Convertibles Bonds Arbitrage Total Returns Formula:

Total Return = Convertible Bonds Coupons (Interest on Long bond)

+ Short Interest Proceeds (Rebates on Short Stock)

– Stock Dividend Yield (Distributions Pay-Out on the Stock Short)

– Cost of Leverage (Margin Cost on the Stock Short)

+ Capital Gain/Loss from Stock

+ Capital Gain/Loss from Bond

Convertible Arbitrage Steps:

• First: properly pick you investment security; one with undervalue debt and overvalue equity.
• Second: place a buying order for the bond at the same time you short the common stock: subject to an all or none execution.

Before we proceed I need to share with you two investment rules of the Arbitrageur Investing System :

1. Never buy a bond that is trading above par (face value).
2. Never short a stock that pays a dividend.

“As long as you understand the market trend of these securities (bullish or bearish)”

Case Study Time

Develop an excel spreadsheet that can calculate the expected total return performance of convertible bond arbitrage trade.