A little over a year ago, I wrote some articles on convertible hedging. Through most market cycles, convertible hedging is an interesting approach. It becomes even more interesting when option premiums are low, as they are now.

When you think about convertible debentures, they are really corporate bonds with an attached call option (the conversion feature). When option premiums are low, traders pay less for the value associated with the debentures’ conversion feature, effectively reducing the conversion premium.

Generally, convertible hedging has been profitable, although over the past year it has not produced the returns that holding Canadian equities outright would have produced. Still, the strategy, when implemented and monitored correctly, has historically produced reasonably steady positive returns. The trick is to understand how convertible hedging fits within a broader portfolio — and not to gloss over the specifics of a strategy — when presented with positive performance numbers. Never forget, past performance is not indicative of future results.

On the surface, a convertible hedge looks like the perfect strategy, a program that produces positive cash flows and can profit handsomely in a trending market. Some would say it is the best of all worlds, a strategy that is designed to win in all market environments, assuming one can garner favourable financing from the brokerage industry and there are no ancillary non-market related issues, such as forced conversions or short squeezes.

Before going further, let’s define a convertible hedge in its most basic form. Essentially, it is a strategy in which the hedge fund manager buys a convertible debenture or a convertible preferred share of a specific company and, at the same time, sells short the underlying common shares. In this article, we will look specifically at convertible debentures, leaving the convertible preferreds for another day.

Consider the following example: Suppose we are looking at XYZ Co., whose common stock is trading at $40 per share and pays a $2 annual dividend. XYZ has a number of convertible debentures, and the one that is of specific interest to a hedge fund manager is the XYZ 8% convertible debenture, which carries a BBB rating and is convertible into the underlying common shares of XYZ at $50 per share.

A typical convertible debenture has an underlying value of $1,000. So in this case, each XYZ $1,000 convertible debenture can be exchanged for 20 shares of XYZ at $50 per share. That exchange privilege provides us with a conversion value for the XYZ convertible debentures. The conversion value is simply what the convertible debenture is worth based on the current price of the underlying shares. Because XYZ common is trading at $40 per share, and we can convert into 20 shares, the XYZ convertible debenture has a conversion value of $800.

Of course a convertible debenture also has a value based on its yield. Suppose that, in the current market environment, the typical yield on BBB-rated corporate bonds with the same term to maturity as the XYZ convertible debenture is 8%. As XYZ has a coupon of 8%, it has an intrinsic value as a BBB-rated corporate bond, which in this case is $1,000.
And as you might expect, in the open market, the XYZ convertible debentures are trading at $1,000.

That brings us to the final consideration when looking at convertible debentures — the conversion premium. In other words, what the value of the bond is relative to its conversion value. We calculate this by dividing the bond’s current price by its conversion value (1,000 dividend by 800 = 1.25). In this example, the XYZ convertible debenture is trading at a 25% premium over its conversion value.

To review, investors or hedge fund managers have to look at three factors when dealing with convertible debentures: the conversion value, the value of the convertible as a straight bond and the conversion premium.

Having decided to buy a convertible debenture, the next step in the process is to sell short the underlying shares. If the manager was looking to put into place a 100% hedged position, he would sell 20 XYZ common shares short for every XYZ convertible debenture held in the hedge fund portfolio.

Suppose the fund was holding $100,000 worth of XYZ convertible debentures (1,000 debentures at $1,000 each). Using these numbers, the hedge manager would sell short 2,000 shares of XYZ common stock at $40 per share.

@page_break@Here’s where the financing and potential cash flow advantages come into play. Using these assumptions, the hedge fund manager takes in $80,000 from the sale of the XYZ common shares. Because the shares are being sold short, the manager is actually selling shares the fund does not own. At some point in the future, the fund will have to repurchase the shares in the open market in order to close out the short sale.

The $80,000 cash flow from the short sale can be used to finance the $100,000 cost of the convertible debentures. The fund is only putting up $20,000 of its own capital to control $100,000 worth of convertible debentures paying 8% per annum.

Here’s the cash-flow kicker: the convertible hedge fund is actually earning $8,000 per year in interest from the convertible debentures, on an investment of only $20,000. That works out to 40% per annum on capital at risk. Seems perfect so far.

Unfortunately, there are costs associated with this trade, not the least of which is the cost of borrowing the XYZ common shares. The fund may be selling short something it doesn’t own, but the investor buying XYZ stock wants to know he will be receiving the common shares. The hedge fund must borrow the shares that are eventually delivered to the buyer. There is a cost for borrowing shares, which we’ll assume to be 1.5% per
annum, or $1,200 per year.

Another complication is the XYZ dividend. Recall that the common shares pay a $2 annual dividend. As the hedge fund has borrowed the stock that was sent to the buyer, the fund must make good on any dividend payments. On 2,000 shares, that works out to $4,000 per year.

At this point, the fund has $20,000 at risk, on which it is earning $8,000 interest income.
It is paying out $1,200 borrowing costs for the short stock, and $4,000 per year in dividend payments. Still, on a cash-flow basis, the fund is ahead by a net $2,800 per year.
More important, that $2,800 per year is earned on only the $20,000 capital at risk. That’s a 14% per annum cash-on-cash return, which is still quite attractive. Whether it is attractive on a risk-adjusted basis remains to be seen. IE