Q. So this is a real classic strategy that a viewer has asked us to explain…
A. Yep. First, we have to review the basic idea of a convertible bond, which have been popular ever since they were invented to help finance the railway expansions of the 1800s. A company issues a bond for $1,000 that is normal except for one thing: the holder can covert the bond into a predetermined number of shares of the issuing company at any time.
Q. So that if the stock price goes up, the investor can convert and get the benefit.
A. Right: investors get a bond with upside. And because of that feature, the bond carries a lower interest rate than it otherwise would. The company is happy, because the conversion, if it happens, will be at a price above today’s stock price– better than issuing equity today. On the other hand, if no conversion occurs, it has issued debt at a below-market rate.
Q. OK, great. Now, where’s the arbitrage thing come in?
A. In taking advantage of mispricings of that embedded option feature. Especially at original issue, the bond price doesn’t reflect the full value of the embedded option. So an arbitrageur buys the bond, and simultaneously shorts the amount of stock into which the bond is convertible.
Q. So doesn’t care how the stock price actually moves…
A. Right. But he should profit as the market price of the bond moves to reflect the real value of the option. It’s actually more complicated than that, because you have to figure in the income from the bond itself, and from the cash you get when you sell the stock short; as well as the interest expense you have to pay for borrowing the stock. And you have to rebalance the trade as the option value moves around over time. But that’s the basic idea.
Q. And how have funds using this strategy performed?
A. Overall, it’s a very strong strategy that does well even when the market slides… os its one of the better kinds of strategies for individuals to consider. However, in absolute panics, like in 08, it fails. So don’t rely on it to shoo away the black swans.