What Is Convertible Bond Arbitrage?

To understand what is Convertible Bond Arbitrage, let’s quickly brush up ‘convertible bonds’ and ‘arbitrage.’ Companies looking to raise short-term capital do so by issuing bonds. In return for investing in them, companies pay a fixed percentage as an interest to their investors. These bonds can be ‘convertible’ or ‘non-convertible’. Convertible bonds yield interest for a fixed period of time, after which they can be converted to equity shares of the company, thus earning the investor a stake and voting rights in key matters. These convertible bonds are traded on the exchanges exactly like equity shares. However, after conversion, the bond’s interest income ceases.

Since shares and bonds are traded as separate entities, there is generally a difference in the pricing of both. ‘Convertible bond arbitrage’ is a trading strategy wherein this price deference is leveraged to make gains. To get this right, traders need to take a long position on the convertible bond and similarly take a short position on the equity stock.

How does the Convertible Bond Arbitrage Strategy work?

Once the positions are firmed up, there are three possible ways in which the convertible bond arbitrage strategy can transpire:

Case 1: The stock price drops.

When the share price falls, the trader will start gaining out of the short position on his equity as it is in the direction of the market movement (the trader can sell high despite price downturns). But at the same time, the bond price will also start falling. This drawdown will, however, be to a limited extent as it is a fixed income security and does not experience great volatility. The difference between the short-position gains and the price drop of the bonds (convertible bond arbitrage) will be the profit made by the trader.

Case 2: The stock price rises.

In this case, the short position on the equity shares starts to make losses. (As the trader cannot sell at the higher market price.) Nonetheless, the bond price will also rise and start covering for the loss as the trader will then exercise the right to convert bonds into equity shares. It must be noted that convertible arbitrage strategy does not shield the trader much against losses and only mitigates the risk to a certain extent.

Case 3: The stock price remains rangebound.

Here you must be thinking that a loss is guaranteed, right? Well, here’s where the benefit of the bonds kicks in. Even if the share price is moving sideways for a certain timeframe, the bond is still yielding returns in the form of interest payments. Hence, even if the short position on your stock is lossmaking, it is offset by the interest earned during that period. In this situation, the trader is likely to make neither a profit nor a loss.

Convertible Bond Arbitrage Example

For the sake of simplicity let’s ignore transaction costs and conversion fees in this example. Our underlying assumption will be that each bond is convertible into 1 share. Now, let’s say that we have the following information:

Stock price = ₹10

Bond Price = ₹5

Strike Price = ₹20

No. of Shares = 100

Our aim here is to convert both assets into cash before the options expire. The bonds will yield a profit only if the share price remains below the strike price.

Case 1: Stock price falls to 0

Here the maximum loss will be the bond price also falling to 0, i.e., a total of ₹500. However, the chances of the stock price suddenly plummeting are very low.

Case 2: Stock price rises to ₹25.

In this case, the bond price will also rise to approximately ₹12.5. The profit in this situation will be:

From equity = (20 – 10) x 100 = ₹1,000

From bond = (5 – 12.5) x 100 = (₹750)

Net profit = 1,000 – 750 = ₹250

Case 3: Stock price stays between ₹5 and ₹10

Here the only loss is the differential between the initial stock price of ₹10 and the market price of the same stock at the time. The same multiplied by 100 will yield the total loss.