So the fund went long on the second-lien bond and short on the convertible bond, establishing twice the exposure in the former than the latter. Though the fund would pay a higher absolute yield in shorting the convertible, collectively this weighting created a positive yield carry.

“The most significant risk we ran,” admits Wiley, “was if A&P stabilized its finances,” in which case the convertible would likely have moved up more aggressively because of its shorter maturity. But the extra weight in the second-lien bond would likely have kept the net value of the trade in the black.  “We choreographed the trade to work in multiple scenarios,” says Wiley.

Turns out that Wiley’s group didn’t have to wait long for the investment to move. By the end of 2010, A&P’s management didn’t see any hope in piling on additional debt and opted for bankruptcy. While interest payments stopped on all vehicles, the price of the convertible collapsed and the uncertainty surrounding the status of the second lien bond was removed. This stabilized the bond’s price. It eventually started to rally as other credit investors began to recognize its underlying value.

At the end of the following year, a triumvirate of investors negotiated the purchase of A&P, agreeing to make all bondholders whole to avoid having to deal with new equity investors. This surpassed Whitebox’s expectations for a positive scenario, and by the summer of 2012 the fund was fully out of the trade.
Fixed-income arbitrageurs don’t usually score big on both legs of a trade. But the unique capital structure issues Whitebox had recognized in this special situation enabled the hedge to turn very pretty.   

Like any investment strategy, fixed-income arbitrage has inherent risks. Because price discrepancies don’t correct overnight, investors must tolerate marked-to-market-induced price declines. That said, a manager needs to be astute enough to know when the trade’s underlying thesis is no longer valid and cut his losses.  

“One of the trickiest aspects of investing in this strategy,” cautions former hedge fund manager Mathew Ridley,  “is understanding how much risk a manager is adopting.  Investors must be comfortable that the manager is not misleading or unduly reassuring them.”

He also cautions investors to understand a manager’s risk concentration. He may have many ostensibly disparate trades. But if a common event can trigger negative results across the portfolio, then it’s not sufficiently diversified.

So investors need to review a manager’s past performance. Invest only in funds where 85% to 90% of all trades have worked within projected time frames. And make sure you understand the arbitrages. If they are indecipherable, stay away.

There are basically only three reasons for failure: One, the manager didn’t set aside enough cash to meet margin calls; two, the trade thesis was defective; or three, subsequent developments materially altered the thesis against the trade.

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