The Convertible Arbitrage Strategy Analyzed

This paper analyzes convertible bond arbitrage on the Canadian market for the period 1998 to 2004.Convertible bond arbitrage is the combination of a long position in convertible bonds and a short position in the underlying stocks. Convertible arbitrage has been one of the most successful strategies of hedge funds.This paper shows that the convertible arbitrage strategy has considerable effects on capital markets.First, there is a downward pressure on cumulative average abnormal returns of the underlying stocks between the announcement and the issuance dates of convertible bonds.Second, short sales of the underlying equity around the issuance dates strongly increase for equity-like convertibles. Third, convertible bonds are underpriced at the issuance dates.All effects are stronger for equity-like than for debt-like convertible bonds.Finally, we find that over a one-year period following the issue, equity-like convertibles earn a return that is more than 23 percentage points higher than the return of debt-like convertibles.In the last years of our sample, convertible arbitrage returns have strongly decreased.This seems to be related to a shift from equity-like to debt-like convertibles by the issuing companies.