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, Hage explained why convertible arbitrage makes sense again. Is the convertible-market recovery going to last, or is it just a rebound like we saw last summer?

Eric Hage: The recovery is a major correction of anomalies that developed over a period of years in the underlying fundamentals of the market. Between 1998 and 2003, many large-cap companies were able to get cheap financing by issuing zero- or low-coupon bonds, and there was a lot of hedge money attracted to this market by simply buying volatility via the convertible market. All of that was corrected last year at the end of a long decline in volatility. We're now returning to the roots of the convertible market, with a focus on small- and mid-cap companies issuing convertibles that offer volatility exposure and positive carry that can be profitably traded by versatile managers. It is also important to note that the new-issue market is now priced at much cheaper levels.

The market is doing well despite volatility that remains quite low. How do you read this?

Volatility gets attention because convertible-arbitrage funds profited by trading heavily on that factor in the period from 1998 to 2002. But good convertible traders avoid losses when one factor declines by extracting gains from other factors, and when other factors are favorable, sizable gains are achievable. That's the case now with cheap merchandise, a better supply-and-demand situation in small- and mid-cap issues and excellent terms. If and when volatility comes back, it will be the cherry on an otherwise delicious sundae.

Why do you prefer small-cap convertible vs. large-cap?

Many small-cap companies offer higher coupons, have no debt other than the convertible and have no credit-default swaps by which to focus trading exclusively on volatility. Therefore, these trades involve a mix of credit, carry and volatility, so the manager must heavily research all three and incorporate them into valuations. One result, but an important one, is that pricing is more inefficient among small-cap issues, and therefore offers more opportunities for the manager who can afford to do heavy research on small issues.

An example of a large-cap issue that we do not own is the recently issued Gilead ( GILD) convertible with a 0.5% coupon. We are not comfortable just betting on the fact that Gilead volatility will increase in the future, while not getting paid to wait by earning a positive yield in the meantime.

Is the space still too crowded with hedge funds?

There were too many hedge funds in this market last year, but today the space is no longer crowded. Redemptions and closings in 2005 produced not only fewer hedge funds in the space, but also a healthier mix of hedging and outright traders in convertibles. On top of that, something else happened: Large hedge funds looking for large positions that influence their returns could not find them in the small deals coming from smaller companies. That left the small-cap space to fewer firms like us. So, in smaller caps, there is a growing pool of merchandise facing less demand from funds, thereby offering plenty of cheap merchandise from which to choose.

Describe one of your current successful trades.

A yield-oriented type of trade that we currently have and that we like is Empire Resorts ( NYNY). We own their 8% coupon convertible bond. Empire Resorts is a gaming and resort-management company that has a harness horse track and 60,000-square-foot video-gaming floor in Monticello, NY. They are partnering with the St. Regis Mohawk tribe in an attempt to build a $500 million casino on this land that will be closer to New York City than either Atlantic City or Foxwoods in Connecticut. Right now they are working with the Bureau of Indian Affairs to get an environmental assessment for the proposed land site approved.

We like the convertible because it currently offers a 16% yield-to-put with the potential to make a lot more than that if they receive approval for the casino and the stock appreciates to its appropriate level.( Editor's note: A put gives bondholders the option to sell the bond back to the issuer at an earlier date than maturity. The yield-to-put is the calculation of the yield, assuming that the bond will redeem at the call date.)

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.

In keeping with TSC's editorial policy, Emma Trincal doesn't own or short individual stocks, and doesn't invest in hedge funds or other private investment partnerships.

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