Do-It-Yourself Convertible Arbitrage

Convertible arbitrage is a popular hedge fund strategy in which a fund takes a short position in the common stock of a company and a corresponding long position in a convertible security issued by the same company. I offer a specific example below, but first I want to highlight the two things the convertible has going for it that make it compelling as the long portion of the arb play:

It usually pays a secured dividend. I say "secured" because in most cases, unlike the dividend paid by a company on its common stock, the dividend for a preferred stock cannot be cut by the company because that would entail a default on the debt that the convertible represents.

The convertible security, true to its name, can be converted into shares of common stock. The number of shares it can be converted into is dependent on the terms that were stated when the security was issued.

A convertible security and the underlying common stock often trade in tandem with each other because of the convertible aspect of the security. In other words, while the security trades like a piece of debt most of the time (because of the secured dividend), it also behaves like a stock. Because it can potentially be converted into common stock at a later date, the closer the stock price comes to the conversion price, the more closely the convertible will trade with the common.

The benefit to a hedge fund of playing this arbitrage is that in many cases when a stock and its convertible have taken a dive (no matter the reason), the convertible will yield a high dividend. Shorting the common and going long the convertible allows the fund to lock in the dividend, reducing its stock risk. If the convertible continues to go down, the common stock likely will be going down even faster, so shorting the common will make money on the position, even when losing on the long position of the convertible. And it bears repeating, there's always the dividend yield to boost results.

So does the strategy work in general? Below are the last five years' results of the CSFB/Tremont Convertible Arbitrage Hedge Fund index -- the aggregate results of the hedge funds tracked by CSFB that focus on convertible arbitrage:

2003: +12.9%
2002: +4.05%
2001: +14.58%
2000: +25.64%
1999: +16.04%

So while the strategy did not outperform the market in 2003, it did produce a double-digit gain, and in the negative market years of 2000, 2001 and 2002, the strategy delivered strong positive returns.