No doubt one of the top hedge fund stories of 2006 is the comeback of convertible arbitrage. But now that it’s humming again, the strategy will need some tinkering to drive it even more in 2007, as the sector becomes increasingly crowded, according to Andy Preston, former CEO of KBC Alternative Investment Management, and co-founder with Ben Chekroun of the newly formed Preston Capital Management. Preston, whose new firm is devoted to conv arb and capital structure arbitrage, told Reuters that one way to help produce even better returns would be an approach that "assesses both a convertible bond’s equity risk and its credit risk." He notes: "Arbitrageurs need to innovate...In the past, in buying convertible bonds, people have removed credit risk in order to derive the embedded call option." That’s old hat, according to Preston, who now favors "looking at them as very complex instruments where there are two, sometimes contradictory, measures of a company’s risk." In his interview, Preston said conv arb opportunities now are "not going long equity volatility, but exploiting the mispricing in relation to company risk, as expressed in equity volatility, compared with risk as expressed in the credit element of the instrument." Predicting that the strategy should produce returns of 10% or better a year, Preston said he buys convertible bonds to include exposure to specific issuing companies while eliminating "some generic credit risk by using credit options."