Synthetic Convertible Bond Arbitrage - "A Primer"

The concept of synthetic convertible bond arbitrage is based on the traditional hedge fund strategy of what is called "convertible bond arbitrage".   In essence hedge fund managers will purchase a convertible bond and then hedge that fixed income instrument by short selling the underlying equity in a hedged position.  

Taking a step back it is important to understand exactly what a convertible bond really is.    A convertible bond is a fixed income instrument issued typically by a corporation which allows the company to issue debt through tradition fixed income markets and structure an instrument which is unique in its' possible conversion at (or possibly before) maturity.    Typically a fixed income instrument is one which pays a fixed rate of interest per annum and then returns the principal at maturity.   A convertible bond, however similar in structure, allows the company or the purchaser to convert the bond into shares of the company stock in lieu of the principal.   This feature could be very beneficial if the company does very well and the stock increases in price while you own the convertible bond.    If not, the company will still pay the stated interest and principal at maturity.  

Since the convertible has an embedded option to convert the bond into stock, most hedgers will utilize some forms of hedging to allow for downside protection should the stock price fall.   This strategy allows the hedgers to make a profit if the stock rises OR if the stock price falls.    SOUNDS GREAT RIGHT?

THE REAL PROBLEM - The real problem with convertible bonds is that the issuance of these instruments has drastically fallen off in recent years, mostly due to tax changes.    

WHAT IF THE ISSUANCE OF NEW CONVERTIBLES COULD BE REPLICATED?    This is where my strategy comes into play.    Stay tuned for more....

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