Thursday, 30 October 2008

CB arb

FT alphaville comments on convertible bond arbitrage (in connection with VW, but that need not detain us here). A few points. First the article says CB arb had sizzled out post-2005 due to lack of issuance. Is that really true? I always thought it had sizzled out because CBs were more fairly priced, so it was no longer obvious that buying vol via the CB and delta hedging was a good idea.

Secondly, there was a surge in CB issuance earlier this year: financial companies sold more than $35bn of convertible bonds in the first nine months of 2008. A lot of this paper was presumably gobbled up by hedge funds keen to get back into the play. And for a while it went well. As the FT reported back in 2007:
Convertible arb has returned from the dead. Two years after investors abandoned one of the pillars of the traditional hedge fund portfolio, convertible bond arbitrage is once again attracting interest – and billions of dollars of new money.

Hedge funds specialising in convertible bonds produced their best performance since 2000 last year, returning as much as the previous three years combined.
That has all changed. The Barclays CB arb index was down 9.3% in September. But why? I am puzzled...
  • Classic CB arb players are long the CB, short stock. This is a long vol position: rising vols should make money. Perhaps some of them were hurt by short selling bans or increased stock borrow costs, but that explanation not seem to explain the scale of the losses.
  • Clearly leverage is more expensive and harder to come by. Advanced CB arb players bought CB options (the right to call the CB on an asset swap basis), though, and that is term leverage. You can't easily repo CBs (can you?) so repo squeeze isn't an issue. Again I don't see quite how this factor would impact CB arb specifically.
  • Credit spreads have gone out, and that will have hurt those funds with naked credit longs, but many funds bought CDS protection on the credit, so again the size of the move is surprising.
So, does anyone know why September was so bad for CB arb?

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Blogger Timothy said...

Hi David,

I was talking to a hedge fund investor about this issue yesterday; the impression I was give was that the CDS protection that "convert arbs" had bought was typically of much shorter than the maturity of the convert causing losses as credit spreads widened. I have never really understood this strategy as the concept of prices being distributed about the forward price over long dates seems a bit flaky.

6:53 am  
Blogger David Murphy said...

Ah yes, that makes sense. CBs are often long dated, but CDS are only liquid at 5 years in many names. So the arbs buy the 5 year and hope to switch into a new 5 year after a while. But if spreads have gone out, lengthening the protection costs money.

The idea is basically vol arbitrage. Buy vol cheap and try to capture higher realised vol than you have paid for my hedging.

8:24 pm  

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