The rise and fall of convertible arbs
One by one, the opportunities to make arbitrage profits out of convertible bonds have disappeared. It's no wonder the smartest hedge funds are bailing out.
GLG, one of the biggest, recently entered talks to sell itself to Lehman Brothers. And a US fund, Marin Capital Partners, was forced to place restrictions on investors that wanted to withdraw their money after fund of funds giant Man Group withdrew seed capital from it, according to reports.
Convertible arbitrage was once a sexy strategy. It requires a mastery of many markets. Convertible bonds are debt securities that can be converted into shares at a premium to the issuer's share price. To arbitrage them, hedge funds buy them and simultaneously sell short the issuer's shares and bonds. This effectively isolates the value of the option to convert into shares buried in the convertible.
Jumping through hoops to create an option like this might seem a bizarre exercise. But complexity is precisely the point. Convertibles were traditionally sold by companies in financial difficulties. The bonds were priced such that the embedded options were sold at a discount to their fair value. This meant that both sides got something out of the bargain.