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B. G., Opalesque Geneva for New Managers: Geneva-based hedge fund managers Alexis Martin and Romain Cosandey believe there will be a lot of valuation dispersion within the convertible bond universe. And that is a good thing for convertible arbitrage strategies.
"We are seeing very expensive bonds and very cheap ones materialise. We expect to rotate the portfolio and benefit from this dispersion. We also expect the new issue pipeline to be very strong, especially for the coming months and the beginning of next year. A lot of convertible bonds will mature next year, especially in the U.S. where the companies will roll their convertible bond debts with new papers," the two managers, who run the Solken Convertible Arbitrage strategy, tell Opalesque.
Going into year-end
Given the prevailing macro/geopolitical uncertainty, sector dispersion and upcoming central banks' actions, there may be more of these higher regimes of volatility, an environment from which convertible arbitrage should benefit (gamma trading). On the other hand, the stabilisation of outflows in the asset class and large amounts of new issues coming to the market post-U.S. election may further modify supply and demand dynamics. This presents many different ways to profit from valuation moves.
"There is also more trading from the investor community in the convertible bond space. As the profile of convertibles changes, they change hands; this trading creates fluctuations, leading to more opportunities," Romain Cosandey says. "It goes with this dispersion that we see in the market. This means many opportunities to trade going forward on this repositioning of the convertible bond community."
Convertible bond market
Convertible bonds, fixed income assets that can be 'converted' into common stock or equity shares, have been the preserve of long-only convertible bond funds since the Global Financial Crisis, according to Janus Henderson, a large fixed income manager. 2020 and 2021 saw significant issuance, as companies opted for convertibles as a quick way to raise capital to repair their Covid-impacted balance sheets. Some of these bonds were highly valued and still found willing buyers. However, this all changed in 2022, when weak equity and credit markets fed through to significant losses for convertibles. This period opened the door to the return of hedge fund market participation.
The arbitrage landscape has changed a bit as the investor base is different from four years ago, Alexis Martin notes. After the bad performance of long-only convertible bonds in 2022, there were a lot of outflows from the asset class from this particular investor base, although this is stabilising. Now, the market is biased towards hedge funds, with the appearance also of cross-asset investors.
In terms of new issues, the U.S. market has been very active as opposed to the European market, they explain. There have been five billion new issues YTD in Europe versus 15 billion maturing or converted. This means the universe is shrinking. "It's a bit worrying for the asset class in Europe, but in other markets, it's been very positive this year."
The Strategy
Solken Convertible Arbitrage, a Luxembourg SICAV, was launched in December 2022, and live trading started in February 2023. It pursues an alternative, relative value strategy generically called convertible arbitrage.
A convertible bond arbitrage strategy benefits from the difference in pricing between a convertible bond and the underlying stock price - usually by taking a long position in the convertible bonds while shorting the stock of the company.
Solken's innovative edge is found in the systematic extension built on top of the common discretionary approach.
The primary share class is up 11.6% YTD (to October 2024) and 17.4% in the last 12 months. During this period, the managers maintained a low volatility level, at 2.7%, and a Sharpe ratio above 4. Comparatively, the Barclay Convertible Arbitrage Index is up 7.5% YTD (est.) and the HFRX Convertible Arbitrage Index up 5.4%.
The strategy is focused on capturing realised volatility and predicting fluctuation in implied volatility, the managers explain. "Both drivers worked well, especially since July when volatility and dispersion rose. Gamma trading was particularly profitable during the equity sell-off in early August, which peaked with the carry trade unwind in Japan. We were also able to capture upside movement in Chinese equity markets later on, when convertible underlying equities trading in Hong Kong or their ADR jumped, pushing up valuations at the same time. Furthermore, we collected new issues that came to the market with an average one to two points premium."
That's material enough to support what they maintain: convertible arbitrage is a good contender for diversification in investors' portfolios.
Related article:
10.Jun.2024 Opalesque Exclusive: New convertible arb fund aims to do without old-school investing
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