Strategy Commentary: Convertible Arbitrage

Mellon

Scott MacDonald, and Derek Stewart, Mellon Global Alternative Investments

An abrupt change in economic sentiment caused equity markets to tumble during the second quarter and the implied expected volatility of equity and equity-linked securities duly spiked upward. On average the implied volatility of US convertible bonds leapt six percentage points from a low of 23.9% on 8 May to 29.9% on 13 June.

Elevated levels of volatility raise the value of convertible bond portfolios, other things being equal, and also give rise to more frequent price dislocations, expanding the breadth and profitability of the opportunity set for convertible arbitrage trades. However, toward the end of June new inflation data calmed the markets, and volatility receded. Our managers were not able to match their first quarter returns, but still generated an average return that exceeded 3%. This compared favourably to their peers, many of whom had been running with light hedges, especially in Europe and Asia, and were consequently exposed as equity markets declined sharply.

Our managers’ returns in the second quarter were primarily driven by issuer-specific events. With acquisition activity running at high levels, attention has been focused on convertible bonds, with takeover protection written into their indentures. Though BAA and DP Ports were the only notable issuers whose convertibles will actually be taken out, many names traded up or down on speculation.

Profits were also made exchanging convertible bonds with issuing companies. Many issuers are keen to refinance their outstanding convertible debt with new convertible securities that include a net share settlement feature. This gives the issuer the right to meet a conversion demand, either by issuing new stock or an equivalent cash sum, the latter option providing a favourable accounting treatment, since it has a less dilutive effect on reported earnings. One of our managers led such a negotiation with commercial bank First Horizon during the quarter, earning a 0.75% fee and incorporating takeover protection in the new security.

For the first time in several years, a number of managers reported profits from trading new issues. Momentum continued from the first quarter and April was in fact the first month in 2006 in which convertible bond issuance exceeded maturities and redemptions. Thomson Financial data shows global issuance of $13.2bn in June, a figure not exceeded since 2003. With greater supply, our managers were able to selectively buy issues that were priced at theoretically cheap levels in the primary market, only for them to immediately richen in the secondary market, providing the opportunity to lock in profits.

On average, the implied volatility of a convertible bond in the US or Europe is approximately equal to its realised volatility, suggesting the universe is currently trading at theoretical fair value, which may at least partially explain the returns achieved there. In Japan the universe has certainly richened beyond theoretical fair value, which may at least partially explain the returns achieved there. However, in the US and Europe convertible markets richened only negligibly during the second quarter and indeed throughout the first half of 2006, yet ‘arbitrageurs’ have generated solid returns. Our managers’ average returns was 8.62% for the first half, with minimal exposure in Japan. Clearly, they have been generating returns from strategies other than pure arbitrage.

Pure arbitrage has in fact rarely accounted for the majority of the ‘convertible arbitrage’ strategy’s returns. Generally, what has been described as arbitrage includes a whole variety of hedged trades. The same issuer specific opportunities are what our managers are finding and exploiting in 2006. These situations all require deep fundamental analysis of the issuer’s credit or volatility profile, and many involve negotiating with the company, yet they also offer limited capacity. This provides a barrier to entry for the large multi-strategy funds, who cannot deploy sufficient assets to make such trades meaningful. While convertible bonds remain a niche asset class, the revival in new issuance and an apparent bottoming in volatility expectations as monetary policy has become less predictable, both bode well for convertible arbitrage strategies.

Trade specifics: BAA/Grupo Ferrovial

On 17 March 2006 Spanish construction company Grupo Ferrovial announced a cash offer of £8.10 per share for BAA, the operator of the UK’s main airports. BAA had two convertible bonds outstanding, one maturing in 2008 and the other in 2009. These bonds each had takeover protection written into their indentures, a fact noticed by many arbitrageurs who established outright positions. Since the company was subject to an announced bid, shorting the underlying stock would likely prove significantly unprofitable. In the event that the deal broke down, the convertible bonds would hold up much better than the stock, underpinned by their fair value as determined by fixed income characteristics and implied volatility.

The bonds became highly sought after and traded at a premium to fair value, at which the takeover protection was fully priced in. Our manager too had made this long trade, but felt the deal was far from a certainty and that the position now offered insufficient compensation for the risk of a deal break. They reversed their position, establishing a short position in the convertible bonds. This was rewarded handsomely at the end of May, as on 25 May the UK’s Office of Fair Trading announced a review of BAA’s monopoly.

The new day Ferrovial made it clear that they intended to continue with their acquisition. However, with the takeover premium largely eroded, our manager re-established their long position. On the last day of May, Ferrovial increased their offer to £9.00 per share, and the convertible bonds duly ratcheted higher. In early June Goldman Sachs, which had previously advised management on how to defend against Ferrovial’s approach, began to put together a consortium of investors to make a competing offer. With the deadline approaching to make final amendments to their tender offer, on 6 June Ferrovial upped their offer to £9.50, which was accepted by BAA. The chart shows how each of BAA’s outstanding convertible bonds ratcheted higher in response to the equity price.