Convertible Hedge: What it Means, How it Works, Example

What Is a Convertible Hedge?

A convertible hedge is a trading strategy that consists of taking a long position in a company's convertible bond (or debenture), and a simultaneous short position in the amount of the conversion ratio in the underlying common shares. The convertible hedge strategy is designed to be market neutral while generating a higher yield than would be obtained by merely holding the convertible bond or debenture alone.

A key requirement of this strategy is that the number of shares sold short must equal the number of shares that would be acquired by converting the bond or debenture (known as the conversion ratio).

Understanding Convertible Hedges

Convertible hedges are often used by hedge fund managers and investment professionals. The rationale for the convertible hedge strategy is as follows: if the stock trades flat or if little has changed, the investor receives interest from the convertible. If the stock falls, the short position gains while the bond will likely fall, but the investor still receives interest from the bond. If the stock rises, the bond gains, the short stock position loses, but the investor still receives the bond interest.

The strategy nets out the effects of the stock price movement. It also reduces the cost base of the trade. When an investor makes a short sale, the proceeds from that sale are moved into the investor's account. This increase in cash temporarily (until the stock is bought back) offsets much of the cost of the bond, increasing the yield.

Example

For example, if an investor buys $100,000 worth of bonds and shorts $80,000 worth of stock, the account will only show a $20,000 reduction in capital. Therefore, the interest earned on the bond is calculated against the $20,000 instead of the $100,000 cost of the bond. The yield is increased five-fold.

Things to Watch for In a Convertible Hedge

In theory, the investor should receive interest on cash received from a short sale which is now sitting in their account. In the real world, this doesn't happen for retail investors. Brokers typically don't pay interest on monies received from the short sale, which would further bolster returns. In fact, there is typically a cost to the retail investor for shorting if the margin is used. If the margin is used (and a margin account is required for shorting) the investor will pay interest on the funds borrowed to initiate the short position. This can cut into the returns gained from bond interest.

While it sounds enticing to increase the yield significantly, it is important to remember that the short sale proceeds are not the investors. The cash is in the account as a result of the short sale but it is an open position that must be closed at some point. The strategy is typically closed when the bond is converted. The converted bond provides the same amount of shares that were previously shortly, and the entire position is closed and finished.

Large corporations, hedge funds, and other financial institutions not trading in a retail setting can likely earn interest on the proceeds from a short sale or can negotiate a short-sale rebate. This can increase the return of the overall strategy, as then the investor is getting interest on the bond plus interest on the increased cash balance from the short sale of stock (less any fees and interest payments on margin balances).

An investor must be confident that the hedge will function as planned. This means double-checking the call features on the convertible bond, making certain that there are no dividend issues, and making sure the issuing company itself has a reliable history of paying interest on its debt. Stocks that pay dividends can hurt this strategy because the short seller is responsible for paying dividends which will eat into the returns generated by this strategy.

Example of a Convertible Hedge on a Stock

Joan is looking for income. She buys a convertible bond issued by XYZ Corp. for $1000. It pays 6.5% and converts into 100 shares. The bond pays $65 in interest per year.

To increase the yield on her investment, Joan shorts 100 shares of XYZ (because this is the conversion amount of the bond), which is trading at $6 per share. The short sale nets her $600, meaning that Joan’s total cost for the investment sits at $400 ($1000 - $600) and her return is still $65 in interest. Using the new cost of investment, the return is now 16.25%.

Joan is protecting that rate of return. If the stock trades lower, the short stock position will be profitable, offsetting any decline in the price of the convertible bond or debenture. Conversely, if the stock appreciates, the loss on the short position would be offset by the gain in the convertible security. There are other factors to consider, such as potential margin requirements and the cost of the borrowing and/or shorting fees charged by the broker.

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