Q&A: Convertible Bond Arbitrage's Comeback

Any other good trades?

First Horizon Pharmaceutical(FHRX) is a specialty pharmaceutical company engaged in the marketing and sale of prescription products -- such as Sular, [a hypertension drug], Fortamet [used to manage Type 2 diabetes], and Prenate [a nutritional supplement for pregnancy]. The company just reported better-than-expected earnings per share and revenue for the first quarter. It's an excellent credit, and if the stock falls, the bond will hold up very well. We also like the fact that the company has takeover protection to ward off hostile bids.

Any good examples of a volatility trade?

In a volatility trade, the more a stock goes up and down, the more money you make. That is because when the stock goes down, you buy more stock, and when it rises, you sell more. The more often it happens, the more profit you generate. Holding the convertible bond and adjusting the hedge on the stock that way is called being long volatility.

A volatility-type of trade that we like right now is Emcore( EMKR). Emcore is a company with a $500 million market capitalization, and its stock has been soaring since early March. They are a leading vendor in the optical-component market that also gives investors exposure to the solar-cell and light-emitting-diode market. They currently have a strong backlog and potential growth in all these areas. Cisco (CSCO) is its largest customer, and they have been developing new LED technology with General Electric (GE).

The 5% coupon convertible bond is attractive to us because we think the stock will be volatile in the near term, and we can make money by essentially being long volatility. Meanwhile, we are also generating a positive yield.

What are the advantages of being a specialized hedge fund vs. being a multistrategy shop?

We strongly believe that single-strategy convertible shops can extract more value from the market. Again, most of the value in U.S. convertibles is in the small deals of smaller caps, and our focus, research, experience and size give us a competitive advantage in extracting value from this area. During the crash of convertibles last year, investors had a preference for large, multistrategy hedge funds, because they were afraid to have a pure exposure to the strategy. Now that the convertible market has improved, more investors are going to be looking at convertible-only shops.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider Empire Resorts to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

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