Playing the Big Unwind

Let’s focus just a bit more on convertible arbitrageurs’ use of leverage, because in it lies the secret to the nontraditional investor’s biggest, easiest, and ultimately safest profits in convertibles. As we noted, arbs usually borrow a dollar or two, and sometimes more, for each dollar of capital. This enables them to turn relatively small gains over the course of the year—several percentage points, earned through a mix of capital appreciation, trading and income—into a return acceptable to institutional investors.

The problem, as with any leveraged strategy, comes when the strategy falls out of favor, as it does every handful of years. The pattern is so predictable it’s almost boring. Institutional investors—primarily funds of hedge funds—see a few years of good performance from convertible arbitrageurs and decide they need to be more involved. This typically happens when convertibles in general have reached full valuations. The influx of new money pushes convertibles to unsustainable levels relative to the underlying stocks and fatigue sets in. Then, after a couple of quarters of weak performance—with the reduced prices actually making convertibles more appealing to reasonable buyers—the big new money wants out. The selling pressure causes prime br....