When the stock market is late into a bull-cycle and bond yields aren’t providing enough income, investors are often left wondering where to turn. There are a number of solutions that ACG likes to include in its clients’ portfolios, and one of those solutions is a strategy called convertible arbitrage. This blog will provide an overview of what a convertible arbitrage strategy is, how you can expect it to perform and considerations for adding it to your portfolio.

Convertible arbitrage starts with the purchase of a convertible bond. Many investors may be unfamiliar with this type of bond, but it is quite simple. It’s similar in most respects to a traditional bond—it is legally bound to fulfill its interest payments and repay its principal, unlike a stock, which can cease dividends and fall to a price of $0 with no recourse for the investor. The difference, though, is that the bond has an embedded option that allows the bondholder to convert that bond into shares of the underlying company’s stock. This is one of the most compelling features of a convertible bond: the investor has the potential to participate in the stock’s upside while also having bond-like downside protection in periods with high stock volatility. Another important feature of convertible bonds is that, unlike traditional bonds, convertibles have a reduced vulnerability to rising interest rates because of their stock-like characteristics.

While convertible bonds are a middle road for volatility between stocks and bonds, held alone they still contain more volatility than is appropriate for many investors. That’s why there’s a second component to a convertible arbitrage strategy. The second component involves selling short the stock of the company for which you just bought the convertible bond. As a reminder, selling a stock short means that your investment appreciates when the stock price goes down and depreciates when the stock price goes up.

Combining these two trades—the purchase of a convertible bond and the short sale of the same company’s underlying stock—results in a risk/return profile similar to that of a bond with a nice total return, but one that is not as sensitive to rising interest rates as is a traditional bond. When a company’s share price increases it will hurt the short position in the stock, but at the same time will lift the price of the convertible bond, and the converse happens when the stock price declines. This offsetting feature reduces much of the equity-like risk in a standalone convertible bond. In the event that the stock declines significantly, the value of the short position will increase, and while the convertible bond will lose value, it will offer more protection because of its bond like characteristics than just stock would.

Convertible arbitrage is an attractive way to position your portfolio for return in a late bull-cycle and low interest rate period. However, there are periods in which this strategy may have underwhelming returns. 1994 is a good example of when convertible arbitrage underperformed. Not only were interest rates increasing, but they were increasing rapidly because the Fed, led by Alan Greenspan, was aggressively hiking interest rates. While this hurt traditional bonds more than convertible bonds, it still provided a headwind to the latter. Also in 1994, stocks had an underwhelming year—the S&P 500 only gained 1.32 percent for the year. Thus the option to convert the bond to stock was not as valuable as it would be in a strong year for stocks.

It's important to understand the conditions in which you may be frustrated with a convertible arbitrage strategy, like the environment in 1994, and also in years when the stock market is soaring high. This strategy likely won’t keep up with stocks in years when, for example, the S&P 500 is north of 15 percent. Keep in mind, the goal of convertible arbitrage is to replace bond-like returns in a way that is less sensitive to interest rates. As a result, the returns may under pace that of stocks.

While the concept behind convertible arbitrage is simple, the execution of it should be done by experts. A convertible arbitrage portfolio manager should diversify away from the risk of a small number of issuers, and they should also seek to profit from the mispricing of a convertible bond relative to its underlying stock. A manager on this strategy should also be carefully adjusting trades as the prices of the convertible bonds and stock prices change so that the risk of each trade is managed appropriately.

Investors, particularly those of retirement age who will be taking portfolio distributions, are in a tough spot these days because of the low interest rate environment. Bond returns going forward won’t be as good as they’ve historically been, and while it’s still important to have them in the portfolio, adding a strategy like convertible arbitrage may serve as a smart alternative.