generated for computer IP 193.131.188.
11
GLG Views
Convertible Arbitrage - The Unloved Strategy
By Steve Roth - June 2010
Given the tendency to chase returns
it may seem rather peculiar to find
the best performing hedge fund
strategy of 2009 consistently at the
bottom of investors’ lists of where
they intend to allocate capital.
However there are several reasons
why this may be justified.
Main reasons for being unloved
The mediocre long term returns with regular
bouts of volatility, the high correlation
between managers and the failure to
benefit from high volatility periods and to
provide protection to portfolios are but a
few. These factors can be explained by
various dynamics today affecting convertible
arbitrage.
The basic principle of shorting stock against
a long convertible position has unfortunately
been negatively impacted by the evolution
of the credit default swap market as credits
have not only become more observable but
significantly more volatile, often more so than
the underlying equities. This has forced many
managers to pay away unnecessary premium
to neutralize some of their mark to market
exposure but also leads to convertibles
exhibiting negative rather than positive
gamma behavior.
As the underlying bonds tend to be long
dated, at a portfolio level the timing of
returns is often driven more by money flows
than by capturing gamma or through specific
events. The monetization of the inherent
cheapness embedded in the securities is
either brought forward as capital flows into
the product and a marginal buyer emerges
or pushed further out in time when outflows
lead to forced selling.
This explains the cyclicality of the strategy
as the vast majority of investors run a net
long position rather than a balanced portfolio
of long and short convertibles. On a more
short term basis, because of the greater
dominance of long only funds who tend to
buy while markets are rising, convertibles
exhibit exactly the opposite behavior to what
one would expect i.e the implied volatility
declines as equity markets fall and option
implied volatility rises.
Perhaps the better explanation is that many
investors were forced to redeem at the
bottom due to drawdown or gating triggers,
and after missing the spectacular rally feel
generated for computer IP 193.131.188.11
that they have missed the opportunity. We
certainly do not expect to see a repeat of last
year but then again we also think that much
has changed to make another 2008 event
unlikely and we currently see enormous
potential in the strategy.
Implications of 2008
on Convertible Arbitrage
The perfect storm we went through in
2008, including short selling restrictions,
liquidations of Lehman Brothers convertible
Steve Roth
collateral and forced deleveraging due to Steve joined GLG in November
margin hikes from prime brokers, forced 2005 to co-manage the GLG
an enormous transfer of paper that saw Market Neutral and GLG Global
convertible arbitrage fund ownership decline Convertible Funds. Prior to that
from about 75% to less than 50%, as long he spent 7 years at Deutsche
only funds and alternative asset class buyers Bank where he was a managing
from equity, high yield and distressed funds director and head of the number
stepped in. one ranked European convertible
business and subsequently co-
The education process that took place head of a proprietary convertible
means a much wider audience is ready to and capital structure arbitrage
take advantage of any dislocations going group. Steve graduated from
Cambridge University in 1992
forward. Within the convertible arbitrage
with an MA in Computer Science.
funds, leverage has also been reduced
and liquidity has become much more of a
focus. Prime broker agreements have been
renegotiated to provide funds with better
protection against the margin changes and
pricing disputes that took place during the
crisis.
Ironically many of the supposedly attractive
semi-private deals that were syndicated
amongst the largest participants proved to
be the hardest assets to sell and these types
of transactions are now only going into funds
with long term lockups. The concern today
“
revolves more around the UCITS funds that
provide daily liquidity but their preference for We are of the
balanced investment grade names does not view that the current
tend to overlap with arbitrage funds. environment is certainly
conducive to above
Current Outlook
”
average returns.
We are of the view that the current
environment is certainly conducive to above
average returns. Firstly proprietary trading
desks have mostly been closed and many
hedge funds have also disappeared or have
had their capital base significantly depleted.
As a result competition is dramatically
reduced and many parts of the universe
remain incredibly cheap.
It is very common, in today’s market, to
be paid to own optionality, be it out of
the money calls on convertibles trading
below bond floor, out of the money puts on
2010-11-04 15:24:09 +0000
 generated for computer IP 193.131.188.11

cashflow breakeven names and change of
control upside that historically would have
commanded an additional premium in those
bonds with attractive language.
Many non investment grade names still
trade at substantial discounts to equivalent
options. The authorities efforts to recapitalise
the banks and aid the economy through
the steep yield curve benefits the strategy
significantly as the absolute cost of funding
positions is incredibly low in spite of the
higher spreads being charged for leverage.
Corporates, having been scarred by the
The supply demand picture is a further
positive technical, as the small size of the
convertible universe compared to money
market funds and equities means a relatively
“ The supply
demand picture is
a further positive
small reallocation to the product will provide
meaningful upward pressure on prices. We
technical, as the small
do expect institutional support for long only size of the convertible
universe compared to
convertible funds to grow as they become
money market funds
more comfortable with what is still seen as a
complex product, and recognize the portfolio and equities means
benefits that convertibles provide. a relatively small
On the supply side, issuance remains well
reallocation to the
below historic averages and the market product will provide
meaningful upward
continues to experiences net redemptions.

”
financial crisis, remain extremely focused on
Europe was the only region to grow last year pressure on prices.
improving their balance sheets. Given the
as the more significant move away from bank
current low interest rates, many are terming
financing to the capital markets required
out their liabilities through the issuance of
other sources of capital than the corporate
long dated bonds to retire short term debt.
bond market.
Others are delevering through the issuance
of equity to fund bond tenders. This is a win- While rates remain low we expect many
win for convertible arbitrage players when issuers will prefer to avoid dilution for the
equity is placed at a discount and bonds minimal cost saving that convertibles provide
tendered at a premium to market. but as interest rates normalise and M&A
activity resumes we do expect issuance
Current Positioning to increase, providing new opportunities
In 2009 there were over 400 tenders, flushes and ensuring the long term health of the
(enhanced conversions) or announced open convertible market.
market repurchases for a total value of $42
billion in the US market alone. In light of our
expectation of ongoing curve steepening,
we particularly like short dated high yield
paper paying 5-15% from companies holding
sufficient cash to meet these obligations,
even after stressing cashflows within the
intervening period.

Applying modest leverage we can generate

attractive performance with limited volatility
and with the potential for the returns to be
accelerated through the above mentioned
corporate actions. With some degree of
uncertainty over the outlook for interest
rates, given the current unorthodox monetary
policies, we also feel more comfortable in the
shorter duration bonds.

Opinions expressed are those of the authors and may not be shared by all personnel of
the GLG group (“GLG”). This document is for information purposes only and does not
constitute an offer or invitation to anyone to invest in any GLG funds and has not been
prepared in connection with any such offer.

generated for computer IP 193.131.188.11 2010-11-04 15:24:09 +0000