The Magic of Convertible Bond Hedging
A friend of mine recently introduced me to The David Rubenstein Show: Peer to Peer Conversations where David, the Founder of the Carlyle Group (Private Equity Firm) interviews other leaders in America’s companies to find out what makes a great leader. But, essentially it’s basically a super-rich dude also interviewing other rich dudes like Bill Gates and Warren Buffett. Jokes aside, it is a really good program to watch to get into the minds of such great individuals and watching it is highly recommended!
Anyway, he showed me the interview with Paul Singer, Founder of the Elliot Fund, and there was a clip where he talked about how he started off making consistent returns by using Convertible Debt Hedging and asked me to explain it. So, this is my promised article to explain exactly what Convertible Debt Hedging is and its pros and cons.
Essentially what Convertible Bond Hedging is, is that it’s a way to make money without exposing yourself to the risk of fluctuations in the market. Many hedge funds use it as a market neutral strategy whilst obtaining high yields. I.e. no matter what the market does you still rake in the dough. What they do is short a stock and buy the convertible bond. (You can probably do this too! I’m going to try it out and see how successful it is)
How does this work? Let’s imagine we buy a convertible bond with an annual return of let’s say 6% for $1000 which can be converted to 20 shares of common stock at the end of maybe 10 years. So, if it were to be converted now the price per share would be $50. If the share price rises, the convertible bond price also tends to rise as the value of the stock is the underlying asset that the bond is based off. (Because convertible bond can turn into shares increasing share price = increasing bond price)
Delta the sensitivity of a convertible bond’s price to a change in the price of its shares. In real life, you have to do some maths on past prices, but I shan’t go into that because its hella complicated and I’m just trying to explain the concept. Anyway, if we assume that a 100% change in the stock price leads to a 50% change in the bond price the delta is 50%.
So, what we do is short $500 worth of the stock, which is priced at close to $50 but for the example let’s just use it. (Read this article on what shorting is) This way movements in the share price should be almost perfectly replicated by the movements in the convertible bond price and since you are short the shares, changes in the stock price so not affect your returns. What you get is not only the 6% minus any interest you need to pay for shorting. You also get a leveraged return because when you short the stock you get $500 back since you borrowed something to sell it on the market, the interest you earn is now doubled at 12% because ($1000*0.06)/500 = 12%. Tadah! You now have double the interest payments minus any short interest payments and basically no exposure to fluctuations in the stock.
What are the risks involved?
The main risk for this strategy is if something occurs that causes the bond price and the stock price to move in opposite directions. An example of this happening is if a credit rating agency downgrades the convertible bond at the same time as some influential individual buys shares in the company. This would increase the share price and decrease the bond price which will bite you in the arse both ways. What are the chances of this happening right? But it did and the most famous case is when General Motors Bonds were downgraded at the same time a billionaire tried to buy its stock.
Another thing that you must avoid doing is to short a stock with high dividends. This is because when you short sell something, you are the one that needs to pay for the dividend payments. So, if you want higher returns doing something like that would be highly unadvisable.
I hope this article helped to clarify what Convertible Bond Hedging is and how hedge funds use it to make high returns that are not affected by moves in the price of the stock. There are also other ways one can play around with convertible bond hedging by using securities with different deltas but there are different risks involved with different deltas and I would probably overcomplicate things by introducing that. If you like this article please follow us on our Facebook page and share this article!