Convertibles can also be used in higher octane fixed-income strategies. Busted converts, which make up about a third of the market today, are typically used in high-yield fixed income strategies.
Because they are hybrids, some advisors lump convertibles in with the alternative class. That makes sense given that long-only convertible bond portfolios are an alternative to traditional corporate bonds, as well as an alternative equity investment.
Treating convertibles as alternatives makes particular sense if the bonds are managed using a relative value or arbitrage strategy. In convertible bond arbitrage, a manager seeks to profit from the cheapness of the bonds, buying the convertible at a discount to theoretical fair value and shorting the underlying stock. Arbitrageurs can also hedge the credit risk and interest rate risk by buying credit default swaps and Treasury futures. The goal is to profit from the anticipated closing of the discount in the value of the bond when it reaches maturity.
In essence, this is a conservative strategy and should over the long term provide returns of 4% to 6% annually, according to Calamos. The Calamos Market Neutral fund, which uses convertible arbitrage and is not leveraged, has returned 3.87% annually over the last ten years. Moreover, the strategy has low correlations to traditional markets. The HFRI Convertible Arbitrage index has a 0.4 correlation to the S&P 500 and a 0.2 correlation to the Barclays Capital Aggregate Bond index, according to AQR.
"This is where the real value is," says AQR's Kabiller. "Investors already have equity and bond exposure. Convertible arbitrage offers risk and returns that investors are not already exposed to," he says.
The risk in the strategy comes when money managers load up on debt to turbo-charge returns. Many hedge fund managers cut their teeth on convertible bond arbitrage, and because convertibles' components are relatively easy to hedge, these funds often carried debt levels three to five times more than their assets. By the beginning of 2008, 75% of convertible bonds were held by hedge funds, according to AQR's 2009 report, "The Limits of Convertible Bond Arbitrage: Evidence From the Recent Crash." The credit crisis in September 2008 led many hedge funds to dump their convertible bond portfolios as financing was withdrawn.
This was not the first time the convertible market had been hit by waves of selling prompted by hedge fund activities. The market went through similar rough patches in 1998 and 2005.
Today, Keele and other convertible bond managers say that hedge funds play a less significant role in the market. "There's definitely been a sea change in the last couple of years," he says. Still, because the convertible bond market is small next to the markets for straight corporate debt or equity, it is risky for its illiquidity and the role hedge funds play in it.
As a mutual fund, AQR's Diversified Arbitrage fund is limited in how much debt it can use, says Kabiller. Leverage is generally kept under 1.2 times assets. Of course, less debt means lower returns. While the firm's convertible arbitrage hedge fund is up 7.5% year to date, the multi-strategy mutual fund is up only 2.75% . The fund includes several arbitrage strategies in addition to convertible bond arbitrage. It is targeted to earn 4% over Treasurys annually, according to AQR.
Despite the recent troubles, convertible bonds still have supporters. "Market events like 2008 are few and far between," says Keele. "If you look at the long-term performance of convertible bonds, they're still very compelling."