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In other words, these are convertibles with high delta, reasonable credit quality, and a solid bond floor. Synthetic put strategies primarily are designed to profit from expansion of conversion premium curvature in case of a stock price decline. The secondary source of income is the static return, net of premium or theta time value decay. Negative cash outflow, or cost of carry, occurs as a result of dividends paid on the short common stock and financing cost of the position.
The difference net cash inflow is known as net position cash flow. Ideally, you want positive net position cash flow to pay for some of the premium of the convert. The principal risk for this strategy is premium erosion or theta time value decay , in which the conversion premium does not hold or increase as the stock price goes down.
Opportunities for gamma trading arise by establishing a delta-neutral, or in some cases a biased, position involving a convertible security with reasonable credit quality, and simultaneous short sale of the underlying common stock. This strategy is primarily based on undervaluation of the convertible on an implied-volatility basis as compared to the historical stock volatility. The key risk lies in the importance of determining an appropriate credit spread to arrive at a realizable level of implied volatility.
Another risk stems from the transaction costs of continued hedging due to the constant buying and selling of shares of underlying stock. As discussed above, the inherent volatility of the stock requires continual buying and selling of shares of underlying common stock in order to maintain delta neutrality of the position.
Vega trades or volatility trades arise by establishing a long position in the convertible and selling appropriately matched call options on the underlying stocks that are trading at higher levels of implied volatility.
Some stocks have longer-dated call options, called LEAPS Long Term Equity Anticipation Securities , with expiration between nine months and three years, that offer higher flexibility for convertible hedge investors. These securities have high bond floor, high conversion premiums, and low theoretical delta. In other words, these convertibles have low premium over bond floor, enabling investors to acquire the call option embedded in the convertible security at a very low price.
A common strategy is to be long the convertible and swap out the credit in the form of an asset swap or hedge with CDS , to result in a low-cost call option. Another strategy is to be long the convertible security and short a very small number of shares of underlying stock, i. The goal of such a strategy is to provide a bullish bias, in case the stock shows strong upward movement. Key risks we see for defensive credit bets are: The credit spread of the long convertible position widens.
Convertible-hedge investors can mitigate the credit risk by either swapping out the credit in the form of an asset swap, or by entering into a default swap. Since these convertibles tend to have very short maturities, they primarily have short-term interest rate and credit-risk exposure. These convertibles tend to trade deep out of the money and have an explicit or implied sub-investment grade rating. The key feature to note in these securities is that investment value or bond floor is difficult to determine, and it is possible that the issuer may not be able to meet its debt obligations.
These securities have high conversion premiums and low theoretical delta. However, the actual delta for these securities tends to be much higher than theoretical delta. Continued weakness in the stock price tends to reduce the equity cushion available to the debt holder, causing the credit spread for the convertible to increase, resulting in the security behaving like stock. The excess short over and above the theoretical delta is intended as a source of credit protection.
Another, less frequently employed method is to short a subordinated security debt, preferred, etc. If there are credit concerns surrounding the issuing company, it is highly likely that the credit spreads on the subordinated security of the company widen.
By shorting the subordinated debt, the investor can offset the losses on the convertible with the profits on the short position on the straight debt. The key risk we see for this strategy is the high cost of carry for the short subordinated position from higher coupon of the short security. Credit risk, which means that the credit spread may widen, tends to be the most important risk for investors in credit sensitive convertibles.
Apart from credit risk, investors should be aware of the following risks:. Changes-of-control put clauses are typically triggered in case of acquisitions wherein a company is acquired for cash or non-stock consideration, instead of stock. Since these convertibles typically trade at very low prices, the change-of-control clause can cause very high returns for the investor.
Due to the reasons explained above, weak protection or absence of a change-of-control put clause can be a risk to investors of credit-sensitive convertibles, whereas strong change-of-control protection could prevent the issuer from being taken over. The short position is established by borrowing shares of underlying stock. When the company is in distress, the borrow ability of its shares tends to come under pressure, causing the borrowing cost to increase.
Since most prime brokers tend to deduct the borrowing cost from the rebate offered for the short proceeds, the increase in borrowing cost hurts the short rebate. This decrease in short rebate negatively affects the profitability of the strategy. Low convertible coupon income.
In summary, investment in these convertibles as credit bets requires careful evaluation of various factors. Other important considerations include the following:. This strategy focuses on convertible securities with reasonable coupon or dividend income relative to the underlying common stock dividend and conversion premium. This strategy offers profitable trading alternatives where coupon or dividend earned and rebate received from the short position offset the premium decay over time, financing costs of the long convertible position and any dividends that may be payable on the short common stock.
In some cases, especially for deep in the money, long dated converts, the cash flow from the position more than offsets the premium of the convertible bond, which means you are getting paid to own a put option. These trades are rare but do exist and are more common today due to fewer convertible hedge funds in the market. A rise in the level of interest rates also affects the profitability of the strategy as it increases the borrowing cost for the long position in the convertible security.
All about converts This blog will discuss all topics pertaining to convertible bonds including credit analysis, indenture analysis and convertible arbitrage trade ideas. Gamma Trades Opportunities for gamma trading arise by establishing a delta-neutral, or in some cases a biased, position involving a convertible security with reasonable credit quality, and simultaneous short sale of the underlying common stock.
Vega Trades Vega trades or volatility trades arise by establishing a long position in the convertible and selling appropriately matched call options on the underlying stocks that are trading at higher levels of implied volatility. Credit Sensitive Convertibles These convertibles tend to trade deep out of the money and have an explicit or implied sub-investment grade rating. Apart from credit risk, investors should be aware of the following risks: Other important considerations include the following: Funding cost of the long position, Leverage of the transaction, and Short-selling rules.
Cash flow trades This strategy focuses on convertible securities with reasonable coupon or dividend income relative to the underlying common stock dividend and conversion premium. For each position, calculate cash flows from: Coupon of the convertible bond Long financing costs Short rabate Dividend payout for short stock In some cases, especially for deep in the money, long dated converts, the cash flow from the position more than offsets the premium of the convertible bond, which means you are getting paid to own a put option.
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