Hedge Funds Return to Bond Trade With Checkered Past

A surge in issuance of a type of bond that can convert into stock on maturity is helping revive a hedge fund strategy that was crushed during the financial crisis.

So-called convertible arbitrage, in which investors try to capitalize on price discrepancies between a convertible bond and its underlying stock, attracted inflows in the first quarter as investors pulled billions out of other strategies, according to data from Nasdaq eVestment.

A typical trade involves taking a long position on a convertible bond and a short position on the underlying stock. If the share price falls, investors profit from the short. If it gains to a certain level, they can convert the bond into equity on maturity. It’s win-win unless refinancing concerns cause a sudden slump in the bond price.

The strategy returned 4.4% in the first four months of 2024, outperforming other relative value strategies, according to Hedge Fund Research. It’s set for another boost as companies look to extend maturities on more than $200 billion of convertible bonds due in the next five years. Other firms are entering the market for the first time, attracted by interest rates that are lower than on conventional debt, and encouraged by stock prices near historic highs.