Credit risk management crucial to a successful convertible arbitrage strategy
Three periods of volatility in 2018, the last of which (in December) caused the biggest drop in US equities since the 1930s, were welcome news for convertible arbitrage fund managers. Simply put, the rise in volatility acts as a positive factor for convertibles as it increases the value of the convertible bond's embedded option.
If, therefore, as some commentators believe, global equity markets become more frothy, the ability for convertibles to provide equity-like returns with less volatility could prove particularly helpful for investors in 2019. During equity market rallies, convertible bonds still give investors upside, but crucially, in a downturn, they provide an element of protection against equity-related risk. This depends on good credit risk management, however.
According to BNP Paribas, convertible bonds in the Eurozone have ridden the wave of the market rally since the beginning of 2019, appreciating by 2.8 per cent.
But as NN Investment Partners head of convertible bond strategies, Tarek Saber, said recently, bearish investors who potentially believe that there will be a recession this year could take some of their equity risk off the table through convertible bonds.
For those seeking to set up capital structure arbitrage trades, because they are part equity and part debt, convertibles sit at an ideal intersection point in the capital structure.
Roy Astrachan is a Managing Partner and Portfolio Manager of Hudson Bay Capital – voted Best Convertible Arbitrage Hedge Fund in this year’s Global Hedgeweek Awards - and is responsible for the convertible and capital structure arbitrage portfolio, which seeks to find opportunities across the capital structure often times using convertibles as an instrument/element within the trade.