Convertible arbitrage funds have largely been flat over the past year with a lack of volatility hindering returns. Issues such as takeover protection, investor interest and shorting convertibles also dotted the landscape. DW's sister publication Alternative Investment News gathered Jeffrey Fachler, portfolio manager at Kellner DiLeo Cohen & Co., Michael Schram, managing partner at Schram Capital Management, and Oliver Dobbs, head of global equities at Tribeca Global Investments, to discuss these issues.
Given that convertible arbitrage has been flat over the past year, how have you dealt with this? Have you changed your strategy?
Jeffrey Fachler: As the marketplace changes in terms of structure and pricing we are constantly adapting to keep pace with those changes. For example, we began shorting volatility (VIX Index futures) as well as more equity options in response to volatility that has dropped to near historic lows. We have also increased our activity in short-term credit names. We have widened our parameters, as the equity sensitive/volatility names as well as cash flow situations, have been somewhat more difficult to find.
Oliver Dobbs: It has not been flat for everyone. Generally funds that were long Vega underperformed last year. If you were long credit, it is likely that you performed well.
Do you look more at credit or volatility for your strategy?
Fachler: We are primarily a volatility driven portfolio but credit is also an integral part of any convertibles valuation. Recently, we have become more active in short-dated yield names in which we are comfortable with the underlying credit.
Michael Schram: We believe that the greatest inefficiencies and, thus, opportunities are in credit. However, we have a multi-dimensional approach that also includes volatility, event-driven, carry, credit arb, and structural trades.
Are you increasingly employing reverse convertible arbitrage trades? Also, are you making synthetic trades, such as shorting credit default swaps to get long exposure to bonds, as a way to remedy a lack of issuance?
Fachler: When we deem it appropriate we will go long equity and short the convertible if our analysis shows that the derivative is overvalued. At present, this strategy makes up a small percentage of our overall portfolio. We are not creating synthetic trades to remedy a lack of new issuance; rather, we remain patient and will wait until the new issue market improves.
Dobbs: We have definitely been looking at more shorting opportunities.
Schram: Generally, we have not shorted convertibles because the return earned by selling the imbedded option results in a short volatility position when volatility is priced very cheaply. It would not take much of a mean reversion movement in volatility to more than offset the little premium earned--i.e. it's a poor risk/reward trade from our view relative to other opportunities in the market. We have not been constrained by the lack of large-cap new deals, and, in fact, favor the small- to mid-cap deals being issued because they are less efficiently priced. However, if the new issue market was constraining we would not seek long exposure via CDS as the first alternative. The CDS market is a good source of liquidity but a poor one for inefficiently priced securities. It is useful in capital structure or credit arb trades when you are expressing a view and value liquidity.
