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Credit risk management crucial to a successful convertible arbitrage strategy

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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. 

“Our investment philosophy is based on our belief that persistent profitability can be achieved across a wide range of market conditions by developing a portfolio of diversified, independent, limited-risk, high- conviction investments,” explains Astrachan.

Hudson Bay Capital is a multi-billion dollar investment management firm operating out of New York and London. The firm’s collaborative culture spans a range of asset classes and strategies including convertibles, credit, volatility, fundamental equities and events & mergers. The team trades these investment strategies utilising quantitative, technical and fundamental analytical techniques. 

Commenting on 2018, and what is required to deliver consistent returns in the convertible arbitrage space, Hudson Bay remarks: “We believe that our performance is due to careful credit risk management as well as our capital structure arbitrage approach. Across our defined investment process called the “Deal Code” system, we manage credit risk by employing methods designed to provide comfort around the expected recovery we own in a near term default and/or credit stress event.” 

By limiting credit risk in this fashion, Hudson Bay isolates optionality from the call option embedded in the convertible as well as structural ‘options’. “Often times, we also benefit from market and company-specific risk,” the team adds.

Convertibles are a popular tool for large corporates to protect their own credit rating when engaging in M&A activity. As the Financial Times reported earlier this month, Vodafone has just raised GBP3.4 billion for the largest ever sterling convertible bond as it sets out to acquire Liberty Global in a deal worth EUR19 billion. 

According to Martin Kuehle, Investment Director Convertible Bonds, Schroders, the degree of possible protection from convertible bonds depends on several factors: the amount of equity exposure, the distance to the bond floor (the safer fixed income element of convertible bonds), the credit risk or estimated risk the company will default and valuation. 

Commenting on the convertibles universe for 2019, Kuehle writes: IT remains the dominant sector, particularly cloud businesses, app services, and payment solutions providers. 

Over at Hudson Bay, a highly disciplined approach towards credit hedging enables the strategy to protect on the downside in the event of severe market or issuer distress.  

The Hudson Bay team constructs its portfolios based on the ‘Deal Code’ system, referred to earlier, which is a scalable, repeatable, and disciplined framework used to organize and monitor investments. 

A Deal Code represents a distinct investment idea and includes the core position(s) and appropriate related hedges, monitored and adjusted over time in an effort to extract alpha from the market. 

The Deal Code system embodies three key criteria:

1. Investments should be beta neutral at the position level wherever practicable.
2. Positions generally should be sized to a limited loss threshold.
3. Positions should be high conviction.

Hudson Bay believes the Deal Code Portfolio Construction Process should allow them to granularly manage and monitor potential downside risks in their portfolio. 

“We believe the key to consistent performance is to create and maintain a diversified portfolio of high-conviction, independent, and limited loss Deal Codes.

“We evaluate our investment ideas at the position (or Deal Code) level. Neutralising beta at the position level simplifies portfolio management and, in our opinion, enables the portfolio to benefit from the power of diversification. Risk guidelines set at the Deal Code level foster the construction of a portfolio of independent, diversified trades with limited downside,” Hudson Bay says.

The team utilises RMon, a proprietary risk monitoring system, to facilitate daily monitoring of portfolio diversification through its own patented statistical measure, known as the Gerber Statistic.

This system was created in response to Hudson Bay’s concern that the common measures for diversification, such as correlation and covariance, have not kept pace with the increasingcomplexity and dynamism of financial markets.

One of the elements of Hudson Bay’s strategy is to apply modelling and indenture expertise to profit from hard-to-model convertible instruments, shunned by many market participants, in order to unlock value from misunderstood instruments.

Another key differentiator is the Fund’s focus on taking advantage of opportunities around events, catalysts and special situations especially when various parts of the capital structure are pricing in different odds of the event taking place, or when the implications of the event for the various pieces of the capital structure are misunderstood. 

Convertible arbitrage is one of the more nuanced and technical hedge fund strategies for investors to consider. But in these uncertain times, with signs that global GDP growth could slow in 2019, including convertibles in one’s portfolio could prove to be a sensible move. 

As such, understanding what makes a good convertibles manager ‘tick’, is crucial, before making an allocation. 

Speaking about the internal culture at Hudson Bay, CIO, Sander Gerber says: “We promote an integrated team culture emphasising collaboration and cross-pollination of ideas across strategies. Our dedicated team seeks to achieve outstanding performance by recognising market inefficiencies and undervalued investment opportunities while maintaining a focus on risk management and capital preservation.”

Looking ahead for 2019, the Hudson Bay team believes that volatility will continue, following the worst performance of the S&P 500 since 1930 in December last year. 

Global political and economic developments point to a new volatility regime for markets, according to Hudson Bay, reinforced by the fact that across all asset classes, “markets continue to display signs of incredible fragility”.

“We think opportunities will emerge from structurally higher volatility combined with limited room for effective economic policy. In our view, volatility drives opportunities for alpha players, and we are excited about the opportunities on the horizon,” concludes the Hudson Bay team.

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