What is Convertible Bond Arbitrage? (How to Get Started)
Convertible bond arbitrage is an investment strategy that seeks to take advantage of price discrepancies between convertible bonds and their underlying stocks.
How Convertible Bond Arbitrage Works
Convertible bond arbitrageurs look for pairs of convertible bonds and stocks that are trading at a discount or premium, and then buy the convertible bond and sell the stock (or vice versa) in order to lock in a profit.
The goal of convertible bond arbitrage is to make money from the discrepancy in prices, not from any movement in the underlying stock price.
There are a few different ways that convertible bond arbitrageurs can profit from their trades.
The most common is to simply buy the convertible bond (also commonly called converts) and sell the stock short.
If the convertible bond is trading at a discount to its underlying stock, then the arbitrageur will make money as the price of the convertible bond rises to match the stock price.
On the other hand, if the convertible bond is trading at a premium to its underlying stock, then the arbitrageur will make money as the stock price rises and closes the gap with the convertible bond price.
Another way that convertible bond arbitrageurs can profit is by selling convertible bonds and buying stocks. In this case, they are betting that the price of the convertible bond will fall relative to the stock price.
If they are correct, then they will make money as the convertible bond price falls and the stock price stays the same (or rises).
The convertible bond arbitrage strategy can be a bit risky, as it depends on a number of factors such as the interest rate environment, the creditworthiness of the issuer, and the volatility of the underlying stock.
Nevertheless, it can be a lucrative way to profit from convertible bonds.
Why Does Convertible Bond Arbitrage Exist?
The reason convertible bond arbitrage exists is because convertible bonds are often mispriced relative to their underlying stocks.
This can happen for a number of reasons, but the most common is that convertible bonds are much less liquid than stocks.
As a result, there is often a larger bid-ask spread on convertible bonds, which can lead to price discrepancies between the convertible bond and its underlying stock.
Another reason why convertible bond arbitrage exists is because convertible bonds are complex financial instruments and have a much shallower market.
They have features of both bonds and stocks (they are bonds that can convert to common stock), which can make them difficult to value.
As a result, it is not uncommon for convertible bonds to be mispriced by investors.
Risks of Convertible Bond Arbitrage
As with any investment strategy, there are risks involved with convertible bond arbitrage, including liquidity risk, interest rate risk, and credit risk.
Liquidity risk
The most common risk is liquidity risk. This is the risk that convertible bonds and stocks will not trade at the same price, or that one security will be much harder to buy or sell than the other.
This is especially true for convertible bonds but can be true for certain types of stocks as well.
This can make it difficult to exit your position, and you may end up taking a loss.
Liquidity risk is one of the main risks in times of market turmoil. This can make it hard to exit a position and can lead to losses if the convertible bond price falls sharply.
Interest rate risk
Another risk is interest rate risk. This is the risk that interest rates will rise while you are holding your position, which will cause the prices of convertible bonds to fall.
If this happens, you may need to sell your convertible bond at a loss if you’re overextended in order to avoid taking on too much risk.
If interest rates rise, the price of convertible bonds will usually fall, as investors will be able to get a higher yield on other investments, including safe government bonds.
On the other hand, if interest rates fall, the price of convertible bonds will usually rise, as they will become more attractive to investors.
Credit risk
Lastly, there is credit risk. This is the risk that the issuer of the convertible bond will default on their debt payments.
This can happen if the issuer runs into financial difficulties and is unable to make their interest payments or repay the principal amount of the bond when it matures.
If this happens, you could lose all of your investment if there is no recovery.
Before you begin convertible bond arbitrage, be sure to understand these risks and know how to manage them.
However, if done correctly, convertible bond arbitrage can be a profitable investment strategy for investors who are willing to take on some risk.
Requirements for Convertible Bond Arbitrage
In order to engage in convertible bond arbitrage, you’ll need to have a few things in place.
Access to convertible bonds
First, you’ll need access to convertible bonds.
You can buy convertible bonds directly from the issuing company or through a broker.
You’ll also need to have enough capital to cover the cost of the convertible bond and the stock.
Ability to short sell
Second, you’ll need to be able to short sell stocks.
This means that you’ll need to have an account with a broker that allows you to short sell, and you’ll need to be approved for level 2 or level 3 options trading.
Knowledge of convertible bonds
Third, you’ll need to have some knowledge of convertible bonds and how they work.
While you don’t need to be an expert to start trading (though it’s always nice if you are), it will help if you have a basic understanding of convertible bond pricing and the factors that can affect it.
Knowledge of stocks
Fourth, you’ll need to have a good understanding of the stock market and how it works.
Patience and discipline
Lastly, you’ll need to have some patience and discipline.
Convertible bond arbitrage can take some time to play out, and you’ll need to be comfortable with holding your positions for extended periods of time.
How to Get Started in Convertible Bond Arbitrage
If you’re interested in convertible bond arbitrage, the first step is to open an account with a broker that allows you to short sell stocks.
You’ll also need to be approved for level 2 or level 3 options trading. Once you have your account set up, you can begin looking for convertible bonds to buy.
You can buy convertible bonds directly from the issuing company or through a broker.
When buying convertible bonds, it’s important to pay attention to the interest rate, the creditworthiness of the issuer, and the volatility of the underlying stock.
Once you’ve found a convertible bond you’re interested in, you can begin looking at the underlying stock, as that’s the necessary second part of the trade to execute the arb strategy.
If all goes well, the price of the convertible bond will increase and you’ll be able to sell it for a profit.
However, if the stock price doesn’t move in the direction you want it to, you may need to hold on to the convertible bond until it matures or until the price of the stock moves in your favor.
Convertible bond arbitrage can be a great way to make money in the stock market. However, it’s important to understand the risks before you get started.
If you’re willing to take on some risk, convertible bond arbitrage could be a great investment strategy to look into.
Ken Griffin and Convertible Arbitrage
Ken Griffin became well-known for his convert arb strategy, doing it as a college student in the late-1980s.
In October 1987, when the stock market crashed, convertible bonds sold off much more heavily than the underlying common stock.
The convertible bonds became so cheap relative to the common stock the arbitrage window opened after shrinking with the market rally and lowering rates environment that had been in place since August 1982.
Ken Griffin happened to notice this and have some capital available to commit to the trade.
After the crash in 1987, stocks restarted their climb higher bringing back demand for convertible bonds.
In this market, Griffin reversed his position, which helped lock in a profit.
Convert arb post-1987
The demand for convertibles grew after the October 1987 crash. Mutual fund companies opened convertible funds for retail investors to join in on the asset class and investors were holding the bonds long term.
Once again spreads narrowed, leaving little arbitrage opportunity available.
By 1999-2000, most convertibles began to trade at a hefty premium to the common stock.
Why did convertible bonds rally?
Convertible bonds are a hybrid instrument of both stocks and bonds.
So, they benefited from both the stock and bond markets rallying during that time.
Convertible bond arbitrage – FAQs
What is convertible bond arbitrage?
Convertible bond arbitrage is a strategy that involves buying convertible bonds and selling the underlying stock.
The goal is to profit from the difference in price between the two securities.
Who does convertible bond arbitrage?
Hedge funds are the most common type of investors that engage in convertible bond arbitrage.
However, individual investors can also participate in this strategy.
Why do companies issue convertible bonds?
Convertible bonds are a type of debt security that can be converted into shares of the issuing company’s stock.
They are typically issued by companies that are looking to raise capital, and they may offer investors a better ROI than traditional bonds.
They commonly offer lower outright yields than traditional bonds – so they can be cheap for the issuing firm – but can offer better returns when they are converted to common stock.
When do arbitrageurs come in?
Convertible bond arbitrage is an investment strategy that seeks to take advantage of price discrepancies between convertible bonds and their underlying stocks.
Arbitrageurs look for pairs of convertible bonds and stocks that are trading at different prices, and then they buy the convertible bond and sell the stock (or vice versa) in order to lock in a profit.
The goal of convertible bond arbitrage is to make money from the discrepancy in prices in a pure arbitrage situation, not from any movement in the underlying stock price.
How do traders execute the convertible bonds arbitrage strategy?
There are a few different ways that convertible bond arbitrageurs can profit from their trades.
The most common is to simply buy the convertible bond and sell the stock short.
If the convertible bond is trading at a discount to its underlying stock, then the arbitrageur will make money as the price of the convertible bond rises to match the stock price.
On the other hand, if the convertible bond is trading at a premium to its underlying stock, then the arbitrageur will make money as the stock price falls and closes the gap with the convertible bond price.
Another way that convertible bond arbitrageurs can profit is by selling convertible bonds and buying stocks.
In this case, they are betting that the price of the convertible bond will fall relative to the stock price. If they are correct, then they will make money as the convertible bond price falls and the stock price stays the same (or rises).
The convertible bond arbitrage strategy can be a bit risky, as it depends on a number of factors such as the interest rate environment, the creditworthiness of the issuer, and the volatility of the underlying stock price.
Nevertheless, it can be a lucrative way to make money in the markets if done correctly.
If you’re interested in convertible bond arbitrage, then be sure to do your homework and understand the risks involved before getting started.
What type of market environment is best for convertible bond arbitrage?
In the 1970s and into the early 1980s, the stock market was weak and interest rates were high, so very few retail clients purchased convertible bonds.
Without that demand, convertible bonds tended to trade cheaply. It was this type of misalignment in value that presented the arbitrage opportunity.
What type of market environment is worst for convertible bond arbitrage?
When interest rates fall, investors tend to begin purchasing convertible bonds again.
This narrows the spread, leaving little arbitrage opportunity.