Convertible arbitrage strategies have been an unloved category of the hedge fund landscape since they underperformed during the financial crisis. Over a three-year period to February 2017, performance has been weak, with the HFRX RV: FI-Convertible Arbitrage index losing 1.4% on an annualised basis compared to a 1.7% loss for the HFRX Relative Value index and a 0.5% loss for the HFRX Global Hedge Fund index. Recent performance has been stronger, with the HFRX RV: FI-Convertible Arbitrage index returning 9.7% for the 12 months to February 2017. However, even with this uptick, we see an improving opportunity set, given a number of beneficial trends.
First, market structure dynamics are supportive. Compared to the equity universe, the vast majority of outstanding convertible bonds are owned by long-only investors, and hedge fund participation relative to the size of the universe has been falling, providing a less competitive environment for those managers still investing. At the same time, the market’s relative valuations are currently beneficial for the asset class. As equity markets are at or near all-time highs, and interest rate rises appear imminent, there is potential for convertible issuance to increase as borrowers seek cheaper sources of financing. The strategy faced headwinds as rates and equity volatility remained compressed, but with volatility expected to increase, the more complex structure of convertibles compared to vanilla equity or fixed income securities should provide hedge fund investors with an additional source of alpha generation.
The regulatory environment may provide an additional boost. The new US administration is looking to reform taxation codes and these changes may be favourable. One proposed change is equalising the tax treatment of bonds and equities on a corporate balance sheet. Currently coupons on debt instruments are tax deductible and therefore a cheaper source of financing versus equity. If this occurs, convertible issuance would become more attractive, as borrowers could issue at a lower coupon and keep the structure of a fixed income instrument, yet benefit from issuing equity more cheaply and delaying dilution.
Given the supportive market environment, an increasingly limited active management penetration and future positive regulatory catalysts, we believe that the convertible bond arbitrage strategy is worth reconsidering for investors looking for niche alternative opportunities.
Source: GAM, Bloomberg, Bloomberg CLA, Hedge Fund Research, MSCI, Thomson Reuters. All returns stated in US dollar terms.