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Beat the Convertible Market

Emma Trincal

Convertible arbitrage has become a wasteland of the hedge fund landscape, yet some players have been able to beat a lousy market. Camden Asset Management, a $2.5 billion Los Angeles-based convertible arbitrage money manager, is one of them. The firm runs an $88 million hedge fund that is down 0.02% year to date. (Most sector indices have posted a negative return in the 4%-6% range.) When one considers that convertible arbitrage began to loose steam in 2003, the 4.3% three-year return of Yield Strategies Fund II (through Sept. 30) makes this fund a winner. In fact, it's the No. 3 hedge fund in this category, according to Hedge Fund Research. John Wagner, Camden's CIO, discussed the secret of his success with TheStreet.com.

TSC: How did you achieve your relatively good performance?

John Wagner: We don't view convertible trading as a commodities strategy, but as a situation where you have to take very careful consideration of each security and all of the subtle nuances. There is a way to trade convertibles where you say, 'I stuck up a model and it's cheap so I'll own it,' and I think we take into account each situation and come up with versions of how that should affect valuation.

Why has convertible arbitrage been so tough?

Because it's a short liquidity strategy: You are long the less-liquid security and short the more-liquid security. A convertible bond is always less liquid than the common stock. With the Fed loosening over the last three years, illiquidity had no premium at all. So you'd expect things to be tough. Volatility has declined for three consecutive years probably due to the looseness of credit and the looseness of the ability to borrow and the free supply of money. Defensive risk-adverse strategies have been out of favor in a world where people are able to easily borrow money. In order to get returns, people have had appetite for more and more risk. So they were sellers of convertibles, which are low-risk securities.

Explain this relationship between risk and your strategy.

People are looking to take on more risk and get more yield. I think if you look at the periods when convertible arbitrage did very well in 2001 and 2002, risk was increasing and the world was very volatile and basically the level of fear in the world was increasing. We did well. Fear right now is at an all-time low, so I sort of feel like as fear picks up, there are lots of reasons for our strategy to do very well. I think we've been through a really tough period and we have generated positive returns for which I am really proud of.

Are we in a recovery mode?

Yes. First of all, with money becoming less easy, the world will become more volatile. With fear at an all-time low, there is a lot of chance for upside. I think so much money has left the strategy that convertible bonds are cheap enough that we need relatively little volatility to make money. So even if the [CBOE volatility index] stays at 11, I think we'll make money. There's a chance that it goes back to 15 or 18, and then we'll make a lot of money.

How did you handle the General Motors (GM - Cramer's Take - Stockpickr) crisis last spring?

In the case of GM and convertible arbitrage, it doesn't hurt just to have the stock go up because you're long the convertible bond, which will go up with your stock shorts. What made GM so painful for convertibles at that time was that the availability of borrowing GM went away. You know, a lot of the hedge funds that lost a lot of money were doing, I think, a far riskier strategy, in that they were long GM debt and short common. And the correlation there is not as nearly well defined. And so the stock rally was faster than the bond rally and that hurt a lot of these guys. In convertible arbitrage, the converts got very cheap. We had a position, we lost money that month, but we made it back since.

What's your GM position like now, in the light of last week's downgrade?

GM is one of our winners. We've done very well in the past few months. The convertible GM will be lucrative for the New Year. We made money by shorting the stock and collecting coupons. We own the GM senior debt convertible.

Any preference for certain sectors?

Now we're looking for situations where the convertible bond is very cheap relative to the existing debt and the common stock in the capital structure. We don't have sector-bias. It's always how the convert looks relative to the debt and the common stock and the listed options. We also hedge interest rate risks by shorting Treasuries.

So many convertible shops have shut down this year. Is that a good thing for the survivors?

I am a hedger, so everything is yes and no. On one hand, it's made it very hard for us to make money this year because when the funds shut down, they sell what we own and make it cheaper. On the other hand, going forward, they won't be there to compete for good ideas. So I think what was bad for last year will be good next year.

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