Hedge Fund Investing Chapter 7: Convertible Arbitrage Strategies

Convertible arbitrage sounds complicated. And honestly, the mechanics are not trivial. But the core idea is surprisingly simple. You buy a convertible bond. You short the stock of the same company. Then you try to profit from the difference.

Chapter 7 breaks down this strategy. Let me walk you through it.

What Is a Convertible Bond?

A convertible bond is a hybrid. Part bond, part stock option. You get regular interest payments like a normal bond. But you also have the right to convert that bond into shares of the company’s stock at a preset price.

Companies have been issuing these since the 1800s. Back then, railroads used convertible clauses on mortgage bonds to raise capital. In the 1950s, airlines did the same. In the 1960s, ITT issued convertibles to fund acquisitions. The instrument has been around a long time.

The Basic Play

Convertible arbitrage in its simplest form: buy the convertible bond, short the underlying stock. You are betting that the bond’s embedded option is undervalued.

Here is the trick. A convertible bond has a convex relationship with the stock price. When the stock goes up, the bond goes up more (because the conversion option becomes more valuable). When the stock goes down, the bond doesn’t fall as much (because it still has value as a regular bond with coupon payments).

So you buy the bond, short some shares to hedge, and you profit from this asymmetry. You make money on the way up from the bond. You make money on the way down from your short. At least, that is the theory.

Three Flavors of the Strategy

Not all convertible arb funds do the same thing. Mirabile describes three main approaches:

Volatility trading. This is the classic version. You buy the bond, hedge with shares, and continuously adjust your hedge ratio as the stock price moves. You are essentially trading the volatility of the embedded option. Managers want bonds where implied volatility is low but actual volatility is high. The more the stock bounces around, the more money you make from rebalancing.

Credit trading. Some managers focus on “busted” convertibles. These are bonds where the stock has fallen so far that the conversion option is basically worthless. The bond trades near its value as straight debt. If you think the company’s credit will improve, you buy the bond cheap and wait. Most convertible issuers sit right around the investment-grade boundary, so there are always opportunities when rating agencies upgrade or downgrade.

Distressed trading. The riskiest flavor. You buy convertibles of companies in or near bankruptcy. The option is worthless, the stock might be pennies. But if the company recovers, you get both bond appreciation from improved credit and rising option value. If it fails, your short stock position and high hedge ratio help cushion the blow.

Most managers blend all three approaches. But every fund leans toward one more than the others.

How They Actually Make Money

Let me give you a concrete example from the book. A manager buys a convertible bond at a price of 108 (meaning $1,080,000 for $1,000,000 face value). They put up $202,500 of their own money and borrow $877,500. That is about 4x leverage.

The bond pays a 5% coupon. The manager also earns interest on the cash from shorting shares. After subtracting borrowing costs and dividend payments on the shorted stock, the net cash flow is about $34,000.

Then the bond price rises from 108 to 120, earning $120,000. The stock goes up too, so the short loses $113,750. Net arbitrage profit: $6,250.

Total return on the full position: 3.8%. Sounds small. But remember the leverage. The return on the manager’s actual capital of $202,500 is 20%. That extra 16.2% comes from leverage.

This is important to understand. The unleveraged return of convertible arb is often barely above the risk-free rate. Leverage is what makes it attractive. Funds typically run 4 to 8 times leverage. In calm markets, some go above 10x. After crashes, they drop to 1-2x.

The Organizational Setup

A billion-dollar convertible arb fund typically has 15 to 20 people. That includes a portfolio manager/CIO, a couple of traders, five credit analysts (mix of senior and junior), operations staff, compliance, a risk officer, investor relations, and a couple of programmers.

The founder usually has a background in either credit research or options trading. Makes sense. You need both skill sets to run this strategy.

Fund Terms

Typical fee structure: 1.5% management fee, 20% performance fee. Quarterly redemptions with 45 days notice. No lockup in many cases. Minimum investment: $1 million.

That’s actually more investor-friendly than some other hedge fund strategies. The quarterly liquidity reflects that convertible bonds, while not the most liquid instruments, can usually be sold within a reasonable timeframe.

The Ugly Truth About Performance

Here is where Mirabile gets honest. The strategy has been through some rough patches.

1994: Down 8.5% when the Fed started raising rates. 1998: Got hammered during the Russian debt default and LTCM collapse. 2002: Enron and WorldCom blew up credit markets. And 2008 was catastrophic. The HFR convertible arbitrage index fell 34% for the year. From September to December 2008 alone, it dropped 27%.

What happened in 2008 is a cautionary tale. Convertible bonds became so cheap they looked like screaming buys. But when Lehman Brothers collapsed, banks that held convertible bonds as collateral started panic-selling instruments they didn’t even understand. Financing dried up. Managers couldn’t fund their positions. Many were forced to liquidate at the worst possible time. Convertible arb portfolios shrank by about 50%.

The overall track record is mixed. The convertible arb composite has underperformed the S&P 500. The worst monthly return for the strategy hit negative 35%. It has a 0.40 correlation to equities, which is higher than you would want for a supposedly market-neutral strategy.

But assets recovered. By 2012, the strategy hit an all-time high above $42 billion in AUM. Roughly 75% of months were positive. Some individual managers did extremely well, even when the index looked bad.

What to Watch For

If you are evaluating a convertible arb fund, Mirabile suggests looking at a few key metrics. Sharpe ratio, Sortino ratio, maximum drawdown, and Value at Risk at different confidence levels. One fund example in the book shows a Sharpe of 2.05, which is very solid, with only a -3.80% max drawdown and 75% positive months.

But aggregate numbers hide individual stories. You need to compare a specific manager against both the strategy index and their peers over the same time period. A manager who looks great over three years might have simply avoided the worst period. Time series matters.

Bottom Line

Convertible arbitrage is a smart strategy on paper. Buy cheap options embedded in bonds, hedge with stock, profit from the gap. In practice, it is extremely sensitive to market crises, liquidity, and leverage. When things go well, you clip steady returns with low volatility. When things go wrong, the leverage that made your returns attractive can destroy you.

The strategy rewards deep credit analysis, disciplined hedging, and good risk management. It punishes anyone who gets too comfortable with leverage in calm markets.

Previous: Chapter 6 | Next: Chapter 8

This is part of a series retelling of “Hedge Fund Investing” by Kevin R. Mirabile.