Convertible Hedge

A convertible hedge is a trading strategy that consists of a taking a long position in a company's convertible bond or debenture, and a simultaneous short position of the same size in the underlying common shares. The convertible hedge strategy is designed to be market neutral while generating a higher yield than would be obtained by merely holding the convertible bond or debenture alone. A key requirement of this strategy is that the number of shares sold short must equal the number of shares that would be acquired by converting the bond or debenture.

Convertible hedges are often used by hedge fund managers and investment professionals, but there is nothing barring individual investors from using it to boost portfolio income yields. The rationale for the convertible hedge strategy is as follows: if the stock trades flat or if little has changed, the investor receives interest from the convertible security plus interest from the short sale proceeds (less any costs to borrow the shorted shares and margin requirements). When shares are borrowed and immediately sold, as in a short sale, the investor who shorts them receives the proceeds of the sale. This effectively lowers the purchase cost of the convertible security, increasing the overall return on the investment.

A convertible hedge is easier to understand in a simplified example. Joan is looking for income due to low interest rates overall. She buys a convertible bond issued by XYZ Corp. for $1000. It pays 6.5% and converts into 100 shares. The convertible bond will have call dates and a set conversion that we are ignoring to keep things simple. So the bond pays $65 in interest per year. Not great. To increase the return on her investment, Joan shorts 100 shares of XYZ, which is trading at $6 per share. The short sale nets her $600, meaning that Joan’s total cost for the investment sits at $400 ($1000 - $600) and her return is still $65 in interest. Using the new cost of investment, the return is now 16.25%.

Best of all, the trade is set up so that Joan is protecting that rate of return. If the stock trades lower, the short stock position will be profitable, offsetting any decline in the price of the convertible bond or debenture. Conversely, if the stock appreciates, the loss on the short position would be offset by the gain in the convertible security. Again, this example has been simplified and there are other factors to consider, such as potential margin requirements and the cost of the borrowing fees charged by the broker.

The convertible hedge is a great lock-in strategy. That said, an investor must be confident that the hedge will function as planned. This means double-checking the call features on the convertible bond, making certain that there are no dividend issues (stocks that pay dividends can kill a short seller) and making sure the issuing company itself has a reliable history of paying.