Q&A: Convertible Bond Arbitrage's Comeback

Convertible bond arbitrage is an old and popular hedge fund strategy that involves buying bonds that can be converted into equity while shorting the underlying stock. For many years, the strategy enabled managers to generate decent and steady returns, adjusting their hedge between long and short positions and making money in up and down markets. That easy trade came to an end by the end of 2004, when the space became crowded with hedge funds chasing a limited supply of deals.

The downturn in convertibles culminated in the spring of 2005 when Kirk Kerkorian surprised the market by buying a huge number of General Motors (GM) shares, causing losses for a great number of arbitragers who were short the stock. The result? Almost every convertible-bond arbitrage fund lost money, a great number of shops closed down, including Marin Capital, and funds of funds significantly reduced their allocation to the sector.

Since late last year, though, the strategy has slowly begun to normalize and return to its historic patterns. New deals have started to flow, and hedge funds that remained in business are posting profits again. In April, the HFRI Convertible Arbitrage Index was up 5.34%, a big change from the negative 2.64% return posted in the same month a year ago.

At this point in the cycle, it's interesting to look back and ask some of the survivors about what went wrong and what they expect looking forward. Eric Hage, founder of Cooperstown, N.Y.-based Mohican Financial Management, is one of those rare convertible-focused hedge fund managers whose returns were not down last year -- he generated returns of 1% after fees in the period. For the past 11 months, through April, his fund was up 14.2%, and it is up 6.8% year to date through April. In an interview with TheStreet.com, Hage explained why convertible arbitrage makes sense again.