So the question we have been asking is; how funds might add value within traditional portfolios? Some would argue that the value is in the hedge fund’s ability to produce positive alpha, or in laymen’s terms, a return that is greater than what one would expect given the amount of risk being taken. In this process we have been looking at some traditional hedge fund strategies. This week, it is convertible hedging. 

On the surface a convertible hedge looks like the perfect strategy to produce positive alpha. The strategy produces positive cash flow supported by favorable financing from the Hedge fund’s primary broker. The cash flow means that the strategy works in flat markets, and can produce significant windfalls, if the manager is weighted properly to capture a specific trend. 

Not that the strategy is without risk. Forced conversions, short squeezes liquidity constraints, changes in conversion value, and / or excess leverage if the manager has tilted the strategy in the wrong direction, all determine the success of failure of the strategy. 

But before going further, let’s define the convertible hedge in its most basic form. Essentially it is a strategy where the hedge fund manager buys a convertible debenture or a convertible preferred share on a specific company, and at the same time, sells short the underlying common shares. For this discussion, we will only look at convertible debentures. 

Here is an example. Suppose we are looking at XYZ company whose common stock is trading at $50 per share, and pays a $1.00 annual dividend. XYZ has issued a 6% convertible debenture that has a BBB rating. It is convertible into the underlying common shares of XYZ at $50 per share. 

A typical convertible debenture has an underlying value of $1,000. So in this case, each XYZ $1,000 convertible debenture can be exchanged for 20 shares of XYZ at $50 per share. That exchange privilege provides us with a “conversion value” for the XYZ convertible debentures. The conversion value simply values the debenture on the basis of the current price of the underlying shares. We’ll assume that XYZ common is trading at $40 per share, and since we can convert into 20 shares, the XYZ convertible debenture has a conversion value of $800. 

Of course a convertible debenture also has a value based on its yield. We will assume in the current market environment that the typical yield on BBB rated corporate bonds with the same term to maturity as the XYZ convertible debenture, is 6%. Since XYZ has a coupon of 6%, it has an intrinsic value as a BBB rated corporate bond, which in this case is $1,000. And as you might expect, in the open market, the XYZ convertible debentures are trading at $1,000. 

That brings us to the final consideration when looking at convertible debentures; the conversion premium. In other words, what is the value of the bond relative to its conversion value. We calculate this by dividing the bonds’ current price by its conversion value (1,000 dividend by 800 = 1.25). In this example, the XYZ convertible debenture is trading at a 25% premium over its conversion value. 

To review, investors or convertible hedge funds must look at three factors when dealing with convertible debentures; 1) the conversion value, 2) the value of the convertible as a straight bond and 3) the conversion premium. 

Having decided to buy a convertible debenture, the next step in the process is to sell short the underlying shares. If the manager was looking to put into place a 100% hedged position, he would sell 20 XYZ common shares short for every XYZ convertible debenture held in the hedge fund portfolio. 

Suppose that the fund was holding $100,000 worth of XYZ convertible debentures (1,000 debentures at $1,000 each). Using these numbers, the hedge manager would sell short 2,000 shares of XYZ common stock at $40 per share. 

Here’s where financing and cash flow comes into play. Using these assumptions, the hedge fund receives $80,000 from the sale of the XYZ common shares. Because the shares are being sold short, the manager is actually selling shares the fund does not own. At some point in the future, the fund will have to re-purchase the shares in the open market, in order to close out the short sale. 

The $80,000 cash flow from the short sale, can be used to finance the $100,000 cost of the convertible debentures. The fund is only putting up $20,000 of its own capital, to control $100,000 worth of convertible debentures paying 6% per annum. 

Here’s the cash flow kicker. The convertible hedge fund is actually earning $6,000 per year in interest from the convertible debentures, on an investment of only $20,000. That works out to 30% per annum on capital at risk. Seems perfect so far. 

Since nothing is perfect, we need to understand the costs associated with this hedge. Not the least of which is the cost of borrowing the XYZ common shares. The fund may be selling short something it doesn’t own, but the investor buying XYZ stock, wants to know he will be receiving the common shares. The hedge fund must borrow the shares that are eventually delivered to the buyer. There is a cost for borrowing shares, which we’ll assume to be 1% per annum, or $800 per year. 

Another complication is the XYZ dividend. Recall the common shares pay a $1.00 per year dividend. Since the hedge fund has borrowed the stock that was sent to the buyer, the fund must make good on any dividend payments. On 2,000 shares that works out to $2,000 per year. 

At this point, the fund has $20,000 at risk, on which it is earning $6,000 interest income. It is paying $800 borrowing costs for the short stock, and $2,000 per year in dividend payments. So, on a cash flow basis the fund is net ahead by $3,200 per year. And more importantly, that $3,200 per year is earned on $20,000 of capital at risk. That’s a 16% per annum cash on cash return, which is attractive. 

Whether it is attractive on a risk adjusted basis – taking into accounts the things that can go wrong - remains to be seen.