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Reveling in volatility

Convertible-bond-arbitrage funds thrive on the sort of uncertainty roiling markets today, but they've also held their own in calmer times.

Convertible-bond-arbitrage funds thrive on the sort of uncertainty roiling markets today, but they've also held their own in calmer times.

By Laurie Kaplan Singh
June 2001
Institutional Investor Magazine

Convertible-bond-arbitrage funds thrive on the sort of uncertainty roiling markets today, but they've also held their own in calmer times.

Last November Mikhail Filimonov, chief investment officer of Alexandra Investment Management, and Dimitri Sogoloff, head of risk management for Alexandra's Global Investment Fund, spotted the kind of opportunity that would elude 99 percent of investors.

Corning stock was trading at $71.25, making for a price-earnings ratio of 67. They thought that seemed very rich for the fiber-optics maker. Corning also happened to have a 15-year, zero-coupon convertible bond issue coming to market at a new-issue price of $74.19 - representing a conversion premium of 25 percent, since each $1,000 face-value bond was convertible into 8.33 shares of Corning common.

So Sogoloff and Filimonov loaded up their convertible-bond-arbitrage fund with the puttable Corning bonds, hedged the credit and interest rate risk through a swap and shorted the stock.

Over roughly the next seven months, Corning shares plunged 71 percent as its hard-hit telecommunications clients cut back on orders. Simultaneously, the convertible bonds - protected by the swap and the put feature (the bonds were puttable at $60.25 in 2005) - declined just 20 percent. By May 15 of this year, the bonds' conversion premium had swollen to 231 percent. A key feature of the bonds, notes Sogoloff, is that they depreciate much slower than they appreciate. Thus Alexandra's gains on the short stock sale have greatly exceeded its losses on the long bond position, so that as of mid-May the total trade had produced a 25 percent return (net of leverage).

Such arcane arbitrage techniques can be used to capitalize on high stock and bond market volatility to lock in attractive returns - even when the underlying securities are declining in price. In last year's turbulent markets, U.S. convertible-bond-arbitrage hedge funds racked up a 15.6 percent return on average, based on the Hedge Fund Research convertible-arbitrage index, versus a 9 percent decline for the Standard & Poor's 500 index. Despite falling convertible bond prices from a surge in supply in the U.S. and Europe, convertible-bond-arbitrage funds this year had gained 8 percent on average through April 30, compared with the S&P 500's 5.4 percent drop and a gain of just 2.7 percent for the Lehman Brothers government/corporate bond index. "The combination of declining interest rates, high stock market volatility and investor uncertainty has been extremely favorable for convertible-bond-arbitrage strategies," notes Alex Ribaroff, founder and chief investment officer of Concordia Advisors, a multistrategy hedge fund adviser in Bermuda.

Yet the success of convertible bond arbitrage is not exclusively a rainy day phenomenon. The 63 U.S. convertible-bond-arbitrage funds tracked by Chicago-based Hedge Fund Research produced a respectable average annual return of 11.8 percent for the ten years through December 31, 2000 (versus 13.8 percent for the S&P 500 during an exceptional decade for stocks and 9.7 percent for the Lehman Brothers government/corporate bond index). What's more, the funds had an average standard deviation (a measure of volatility) of just 3.5 percent, compared with 13.9 percent for the S&P 500 and 5 percent for the Lehman bond index, and correlations to the S&P 500 and the Lehman index of only about 38 percent and 19 percent, respectively.

Many large investors see the funds as a sensible way to diversify in the face of continuing market uncertainty. "Investors are looking more closely at uncorrelated investment strategies," points out Alexandra Global Investment's Sogoloff. Over the five years through 2000, his British Virgin Islands-based fund, with $500 million in gross assets, had an average standard deviation of approximately 7 percent and an average correlation to the S&P 500 of less than 10 percent while returning 14 percent a year on average. "We are attempting to produce returns that are uncorrelated with the broad markets," says Sogoloff. This year through April 30, Alexandra Global Investment Fund was up 12.5 percent.

But market-neutral does not mean risk-free. Convertible-bond-arbitrage funds are vulnerable to dislocations in supply and demand that can cause liquidity to dry up, as happened in 1998, when many funds lost money. And in markets with very low volatility, convertible bond funds can have a tough time.

Sogoloff and Filimonov strive for an absolute return of between 13 and 15 percent - in line with the stock market's historical performance - but with the volatility of short-term Treasury securities. Like all convertible-bond arbitrageurs, they seek to exploit pricing inefficiencies between convertible bonds and the underlying stocks. "We're looking for undervalued bonds with overvalued underlying stocks," explains Filimonov. Typically, they buy cheap convertible bonds and simultaneously sell short the expensive underlying stocks in a ratio designed to neutralize the bonds' equity sensitivity and lock in a stream of income from the bond coupons. They then hedge as many other risks as possible, including currency fluctuations, through asset and credit swaps.

The fund aims to be market neutral. The coupon income combined with the interest income on the proceeds from the short sale - usually multiplied two- or threefold by leverage - compose the fund's standstill rate of return. For Alexandra this typically runs in excess of 8 percent and is the most important of the fund's three major sources of return.

The second most important is so-called volatility, or delta, trading. Since a convertible bond is essentially just a bond with an embedded option, its sensitivity to fluctuations in the price of the underlying stock changes as the option moves in and out of the money. Thus, to keep the fund fully hedged at all times, the managers must continuously adjust the fund's position in the underlying stock. As the stock price increases and the option moves into the money (causing the bond to become more equity-sensitive), the managers must beef up the hedge by selling more stock. Conversely, as the stock price declines and the option moves out of the money, the managers must reduce the hedge by buying back the stock. This continuous round of selling the stock when it's expensive and buying it back when it's cheap can produce a handsome profit. "The more volatile the stock, the more opportunity to adjust the hedges and to make money trading," Sogoloff explains. Delta trading contributed 7.6 percentage points to the fund's 2000 total return of 18.4 percent.

The third major contributor to returns are the gains from the fund's mispriced securities' becoming fairly valued, as in the Corning example. "The beauty of a convertible-arbitrage strategy," says Sogoloff, "is the existence of an identifiable event that will cause prices [of convertible bonds and underlying stocks] to converge."

Like most of their peers, Sogoloff and Filimonov rely on computer models to sift through a global universe of between 3,000 and 4,000 convertible bonds to identify arbitrage opportunities. But their decision to invest or not is based on old-fashioned fundamental research and credit analysis. "It's critical that we understand the reason for the security's mispricing and the impetus for a potential valuation improvement," says Sogoloff. "This is what we get paid for." The bull market in technology shares created pricing disparities between convertible bonds and the underlying stocks that, in Filimonov's words, "reached ridiculous valuations and created enormous opportunities for arbitrageurs." Some of Alexandra Global Investment Fund's more remunerative arbitrages last year involved Juniper Networks, Solectron Corp. and Ciena Corp.

The Old Greenwich, Connecticut-based Forest Fulcrum Fund and its offshore twin, the Forest Global Convertible Fund, are two of the most successful convertible-bond-arbitrage funds of the past six years. Along with an average annual return in excess of 15 percent, they've had a low standard deviation of roughly 4.5 percent, a high Sharpe ratio (a measure of return relative to risk) of 1.8 percent and an extremely low correlation to the S&P 500 and ten-year U.S. Treasury bonds of 0.02 percent and -0.01 percent, respectively. In this recession-wary climate, the Forest funds are emphasizing higher-than-usual credit quality in anticipation of a further widening of credit spreads. "We are very fundamentally driven, and we pay a lot of attention to understanding where we are in the market cycle," says Michael Boyd, chairman of Forest Investments, adviser to the funds. Run on a market-neutral basis, the funds were 50 percent invested in the U.S., 45 percent in Europe and 5 percent in the Pacific Rim (mostly Japan) in mid-April. "There's a lot of opportunity now in Europe," says Boyd.

A more recent entrant to the convertible-bond-arbitrage arena, New York's West Broadway Global Arbitrage Fund, focuses exclusively on Japan. In the three years since its April 1998 inception, the fund has produced an average annual return of 20 percent (net of fees and expenses), with a standard deviation of 1.9 percent and a -0.1 percent correlation to the S&P 500. "The Japanese convertible bond market has unique structural features that contribute to pricing inefficiency and create significant arbitrage opportunities," says Dwight Eyrick, managing partner of West Broadway Partners.

Given the outlook for further interest rate declines, low inflation and a high degree of uncertainty in markets worldwide, convertible-bond arbitrageurs may find the climate congenial for some time to come. "Investors have a pretty quick trigger finger these days," points out Eyrick, "and this makes the markets very volatile." And volatility, of course, is just what convertible-bond arbitrageurs crave.