Convertible bond trading strategies
Trading convertibles requires a level of sophistication. Most preferred stocks trade on the NYSE so this is not an issue.
All bonds are unlisted on exchanges and requires trading through market makers. It is imperative that you have the ability to trade throughout the street. One needs to investigate their source of trading and insure the ability to trade throughout the street.
Clearly, the environment we are in today is one of uncharted waters. It has most definitely been a rocky road. Convertibles most definitely offer investment opportunity and can aide investors with their portfolio. Choosing possible convertible candidates is a different process than buying common stock. As previously mentioned preferred stocks are not an issue because they trade NYSE.
Keep in mind that there are only about 75 issues. Convertible bonds trade OTC and must be transacted through a market maker. The first thing I do is run a search through my Thomson for maturities running five years and a search running up to fifteen years maturity. The next process is to compile a list of investment possibilities and confirm availably. Many times this cannot be accomplished at an adequate price. As mentioned previously, an investor in bonvertibles must assure that they have proper ability to trade bonvertibles.
If you are trading through a broker at one of these firms you must keep in mind that you are limited to their offering inventories. Their offer is your sole ability. In addition, if you liquidate you are subject to their bid. Yield has a most definite bearing on investment decisions. This can be beat handsomely with bonvertibles.
Bluntly put, if the company you invest a bonvertible with does not go bankrupt before maturity, you will receive your yield. Today is a world of unchartered waters and requires close examination as we all have seen things happen never seen before. My intention when composing my investment list is to hold all investments until maturity.
The next goal is to establish belief that the company will remain solvent. I then will look at the technicals of the issue. Since the investment is longer term than day trading stocks I will even look at the fundamental recommendations of the stock. Lastly, I then will examine the yield to see if the situation is attractive on just this basis.
Naturally, the attraction comes if a positive move in the stock occurs. Regardless, the yield to maturity may be a worthwhile benefit. Steve Weitz has been trading stocks and commodities for over 30 years. Hutton, Shearson Lehman, and Paine Webber. He is currently an independent stock broker with a California broker dealer and an introducing broker trading commodities.
To Learn more visit www. In other words, these convertibles have low premium over bond floor, enabling investors to acquire the call option embedded in the convertible security at a very low price. A common strategy is to be long the convertible and swap out the credit in the form of an asset swap or hedge with CDS , to result in a low-cost call option.
Another strategy is to be long the convertible security and short a very small number of shares of underlying stock, i. The goal of such a strategy is to provide a bullish bias, in case the stock shows strong upward movement. Key risks we see for defensive credit bets are: The credit spread of the long convertible position widens. Convertible-hedge investors can mitigate the credit risk by either swapping out the credit in the form of an asset swap, or by entering into a default swap.
Since these convertibles tend to have very short maturities, they primarily have short-term interest rate and credit-risk exposure. These convertibles tend to trade deep out of the money and have an explicit or implied sub-investment grade rating. The key feature to note in these securities is that investment value or bond floor is difficult to determine, and it is possible that the issuer may not be able to meet its debt obligations. These securities have high conversion premiums and low theoretical delta.
However, the actual delta for these securities tends to be much higher than theoretical delta. Continued weakness in the stock price tends to reduce the equity cushion available to the debt holder, causing the credit spread for the convertible to increase, resulting in the security behaving like stock. The excess short over and above the theoretical delta is intended as a source of credit protection.
Another, less frequently employed method is to short a subordinated security debt, preferred, etc. If there are credit concerns surrounding the issuing company, it is highly likely that the credit spreads on the subordinated security of the company widen.
By shorting the subordinated debt, the investor can offset the losses on the convertible with the profits on the short position on the straight debt. The key risk we see for this strategy is the high cost of carry for the short subordinated position from higher coupon of the short security. Credit risk, which means that the credit spread may widen, tends to be the most important risk for investors in credit sensitive convertibles.
Apart from credit risk, investors should be aware of the following risks:. Changes-of-control put clauses are typically triggered in case of acquisitions wherein a company is acquired for cash or non-stock consideration, instead of stock. Since these convertibles typically trade at very low prices, the change-of-control clause can cause very high returns for the investor.
Due to the reasons explained above, weak protection or absence of a change-of-control put clause can be a risk to investors of credit-sensitive convertibles, whereas strong change-of-control protection could prevent the issuer from being taken over.
The short position is established by borrowing shares of underlying stock. When the company is in distress, the borrow ability of its shares tends to come under pressure, causing the borrowing cost to increase. Since most prime brokers tend to deduct the borrowing cost from the rebate offered for the short proceeds, the increase in borrowing cost hurts the short rebate. This decrease in short rebate negatively affects the profitability of the strategy.
Low convertible coupon income. In summary, investment in these convertibles as credit bets requires careful evaluation of various factors. Other important considerations include the following:.