There was a time when convertible hedging — in which you hold long convertible debentures while shorting the underlying common stock — was a common hedge fund strategy. That’s not so much the case today.

Coming out of the subprime mortgage crisis, the strategy had significantly underperformed a long equities strategy because, during the crisis, there was a perception that convertibles carried the same risk as the underlying common shares.

There are other obstacles, including the challenge of finding a prime broker who is willing to deal in over-the-counter securities, which is how many convertibles are traded. As well, there are far fewer convertible securities being issued, so the market is smaller.

Convertible hedging relies on positive cash flow, which hinges on two things: the prime broker, who is responsible for setting the terms of the financing; and whether the convertible yields more than the underlying common shares. This is not a given in today’s market, as many dividend-paying common shares yield more than a typical 10-year corporate bond.

As with any investing strategy, you must evaluate its potential within the context of a broader, traditional portfolio. You must be careful not to gloss over the specifics when being presented with positive performance numbers.

Keeping with that theme, it is instructive to understand first how a convertible is valued. Suppose a hedge fund manager is looking at the hypothetical XYZ Co., whose common stock is trading at $40 a share with an annual dividend of $1. XYZ also has a BBB-rated convertible debenture with a 5% yield, which can be exchanged into 20 common shares of XYZ at $50 a share.

That exchange privilege provides us with a conversion value, which simply values the convertible on the basis of the current price of the common shares. With XYZ common shares trading at $40 each and an exchange rate of 20 shares, the convertible has a conversion value of $800.

A convertible also has a value as a BBB-rated corporate bond. We’ll assume BBB-rated corporate bonds, with the same term to maturity, yield 5% — which, given the XYZ coupon of 5%, implies a value of $1,000.@page_break@That brings us to the conversion premium, which is the convertible’s market value divided by its conversion value. With a market value of $1,000 and a conversion value of $800, the conversion premium is 25%.

To review, there are three factors to consider when dealing with convertibles: the conversion value; the value of the convertible as a straight bond; and the conversion premium.

Having purchased the XYZ convertible, the hedge fund manager then sells short XYZ common shares. If the fund is hedging 100% of its long position, the manager would short 20 XYZ common shares for every XYZ convertible debenture it holds. Assuming the fund holds $100,000 in XYZ convertible debentures (100 debentures at $1,000 each), the fund manager would short 2,000 shares of XYZ common stock at $40 a share.

Here’s where the financing and potential cash-flow advantages come into play. Using these assumptions, the hedge fund takes in $80,000 from the sale of the XYZ common shares. That money can be used to finance the $100,000 cost of the convertible debentures. Thus, the hedge fund has to put up only $20,000 of its own capital to control $100,000 worth of convertibles yielding 5%. That’s $5,000 a year in interest on an out-of-pocket cost of $20,000.

However, there are costs associated with this strategy — not the least of which is the fee the prime broker will charge for borrowing the XYZ common shares. The cost for borrowing shares varies, but for this example, we’ll assume it to be 1.5%, or $1,200, a year. The hedge fund is also responsible for the $1 annual dividend on 2,000 shares.

At this point, the hedge fund has $20,000 at risk on which it is earning $5,000 interest income, minus $1,200 in borrowing costs and $2,000 a year in dividend payments. On a net cash-flow basis, the fund is ahead by $1,800 a year.

More important, that $1,800 is earned on only $20,000 capital at risk, which translates into a 9% cash-on-cash return. But is that return attractive, given the risks?

XYZ could decide to raise the dividend, which would mean less positive cash flow for the hedge fund. XYZ common shares also could jump in value; if they rise faster than the convertibles, the conversion premium would shrink, creating a loss in the hedge fund.

The convertible hedge works well when the markets are trading in a relatively narrow range because the unitholders benefit from the positive cash flow. The strategy works best when markets are falling because the common shares are likely to fall faster than the convertibles, causing the conversion premium to widen.

Presumably, in a falling market, the convertible’s yield would support its price, which is the best scenario for the 100% hedged strategy. IE