Niche strategy enjoys its moment in the spotlight! Convertible arbitrage returned nearly 6% in the first seven months, becoming one of the best strategies for hedge funds this year.

Notice that a niche hedge fund strategy involving convertible bonds is currently experiencing a moment in the spotlight, as the synergy of market forces has created ideal conditions for this type of mixed securities trading. According to an index tracking 120 funds with total assets of $84 billion, the so-called convertible arbitrage strategy - which profits from capturing the pricing differences between convertible bonds and their underlying stocks - has achieved a return of nearly 6% as of July, making it one of the best performing hedge fund strategies in the first seven months of this year. Meanwhile, the strategy's inflows are heading towards the largest annual increase in 18 years. The background for the rise of this arbitrage trading is that corporate credit quality is robust, and the stock price volatility of relatively small companies, including those in the volatile cryptocurrency sector, is increasing - these companies are increasingly entering the convertible bond market. Danilo Ripa, Head of Multi-Strategy Credit and Convertible Bonds at Man Group Solutions, said that the current environment is a "perfect environment" for reaping profits for trading strategies that involve buying convertible bonds and shorting stocks to profit from stock price fluctuations. "We are witnessing a stable credit environment combined with unprecedented high stock volatility," Ripa pointed out. Convertible arbitrage receives inflows once again Convertible bonds are a hybrid instrument that can be converted into equity when the stock price reaches a certain level - essentially a debt with embedded call options whose value is closely linked to stock volatility. Last year, such trades began to rise in institutions such as Man Group and AQR Capital Management, with numerous funds entering into "refinancing trades" involving convertible bonds issued near maturity in the context of the COVID-19 pandemic. Hedge funds bought these bonds, betting that they would be redeemed and rolled over into new trades. As the pool of eligible refinancing targets narrows this year, investors are increasingly focusing on the equity option component of convertible bonds, profiting from the interaction of trading convertible debt with common stocks through stock price fluctuations. Although overall market volatility measured by major indexes has indeed eased since April, individual stocks still exhibit significant volatility. Bloomberg compiled data shows that the median 30-day realized volatility of constituents of the Russell 3000 Index is currently above 40, four times the volatility of the index itself. "Underneath the surface, stock volatility is everywhere. This is absolutely a key driving factor," said David Clott, Portfolio Manager at Wellsley Asset Management, a specialist in convertible bonds. "High stock valuations, ongoing tariff debates, inflation and interest rate concerns, along with other geopolitical disruptions, all provide ample reasons for the continued presence of volatility." Convertible arbitrage hedge funds achieve robust returns The earnings season further exacerbates market volatility, as stock price reactions to performance beating or missing expectations continue to create trading opportunities. Clott noted that a stable credit environment provides stability in trading for these tools. This month, Furu Company plummeted nearly 50% due to earnings missing expectations, resulting in profitable arbitrage trading. In another case, renewable energy company Array Technologies surged 47% after new guidelines from the US Treasury Department boosted the prospects of CECEP Solar Energy industry, leading traders of the convertible bonds due in 2028 and 2031 to profit handsomely. Issuance boom Issuers related to cryptocurrencies have become particularly attractive targets for arbitrage trading. Eli Pars, Co-Chief Investment Officer at Calamos Advisors, pointed out that since Michael Saylor's MicroStrategy began issuing convertible bonds to fund bitcoin purchases, companies like Marathon Digital Holdings and Coinbase Global have followed suit. These companies currently account for nearly 10% of the convertible bond market, compared to almost zero a year ago. As their valuations are linked to one of the most volatile asset classes in the market, this area continues to provide arbitrage trading opportunities, Pars added. The wave of new bond issuances also fuels this trend. According to Barclays Capital data, as of August 22, the issuance of convertible bonds in the US has reached approximately $65 billion, surpassing the total for the entire year of 2023 and setting the fourth-highest record for the same period in over two decades. The rich lineup of issuances supports so-called relative value spread trading, allowing participants to profit from the volatility differences between similar assets and credit-equity spreads. "For convertible arbitrage fund managers, the size and diversity of new trades significantly expand the opportunity set," said Barclays Capital strategist Jack Leung.