Understanding Convertible Arbitrage and Market Neutral Products Part 2 â€¦.The Death of Sam Wo and what it meansBy Edward Strafaci
In our last Thoughtful Arbitrageur, we began our discussion of market-neutral products and, in particular, Convertible Arbitrage. We presented a fictional convertible security, the ABC 5% convertible bonds maturing in 10 years. This bond is call protected for three years, and pays interest semi-annually. The bond is convertible into 40 shares of ABC common which trades at $20 per share and has a dividend yield of 2%.
As promised, we will serially lead you down the path toward understanding market-neutral strategies. Keep in mind that our ABC Bond is what arbitrageurs call a “plain vanilla bond.” “Plain Vanilla” is a security which is basic to the product. Though we will review more exotic creatures later, in order to learn we must first crawl. If you review our last piece, you will be up to date. With that said, we now look at the special considerations one must ponder in order to become proficient in the convertible arbitrage field. This will set the stage for our next missive, which will center on the short sale of an equity which hedges the convertible.
Above all else, read the fine print
Every convertible has a document that spells out the contract between the purchaser and the issuer. As in catching a ball with two hands in baseball, it is good discipline to become familiar with these agreements. For a convertible bond, it is an indenture. For a preferred, it is called the offering memorandum and the articles of incorporation. As in most legal treaties, much is boilerplate. However, there are a couple of key features to be aware of:
The Conversion feature : In this section, the issuer spells out the terms of convertibility. Here, you will learn the mechanism for tendering your bond, or preferred, for common shares. Essential to this, an investor can ascertain how the mechanism is adjusted for special events. Stock splits, mergers or restructurings are among the developments that can impact the convertible holder. As in most detail oriented pursuits, with time and practice, the investor will almost be able to anticipate what the terms will look like. A great shroud of the mystery in convertible investing lifts with a comprehension of this topic.
The Call Provision: This is clearly a crucial part of the document. A convertible’s call feature effectively sets a time limit on the option portion of the security. One needs to master the terminology used in this section since “time to expiration” is of the essence in options investing. Additionally, a key feature to watch is whether a convertible security has a premature, or in the vernacular, “screw” provision. This provision allows a company to make a final call of the security just prior to a bond or dividend payment thus, “screwing” the holders out of recompense. The astute observer learns how to spot such pitfalls.
Other Representations: Finally, there are considerations that affect almost every bond, convertible or otherwise. The convert player must be aware of covenants that will protect the bond’s creditworthiness. If the issuer takes actions that may diminish the company’s ability to pay coupons, this is the where the lender is protected. Special events such as leveraged buyouts, acquisitions or spinoffs have at times crippled a bondholder. Knowing how stringent these covenants are, plays a major role in fixed income investing. Once again, familiarity and experience clearly come into play. The arbitrageur, who pays special attention to these details, is clearly rewarded. In effect, he is buying an additional liability policy.
Just like a Gemologist, know your market: The smart shopper, whether in a supermarket or a souk, knows what is available and where there is value. Just as a gemologist gauges the worth of precious stones, the clever arbitrageur appreciates the convertible menu. Among factors to consider are liquidity, availability and company history. Two identical looking bonds may in fact, trade much differently for a variety of reasons. Certain convertibles always trade dearly while others are constantly discounted.
I remember a Home Depot issue that always exhibited an unusually large premium. This was due to the fact that certain convertible buyers loved the underlying equity. There are times when a bond, or preferred, will inexplicably stay outstanding long after its call protection expires. While it would be logical to assume a call, the security continues to pay interest or dividends. This may be explained by a quirk in the issuer’s finances or perhaps for reasons only known to executive management. The trick is to know these nuances and profit from them. Here again, hard work is rewarded. That is why some of the sharpest investors, like Buffett, favor this market. An edge that can be obtained through diligence, preparation and practice is significant.
Caveat Emptor - the convertible tides shift from time to time: Lastly, there are periods of illiquidity and those of exuberance in the convertible sector. Converts may stay rich for years and quite suddenly, the world changes. This may be due to a tough economic period, volatile interest rates or geopolitical episodes. As a farmer prepares for a drought, the astute convertible arbitrageur must always manage a portfolio with tough times in mind. Keeping leverage low and sticking to better quality are just some of the ways to weather a malaise. Knowing that this is possible is power enough to shepherd you through a down market. In the final analysis, it is these cycles that create lush prospects.
We conclude this chapter on Convertible Arbitrage with this advice: It is the idiosyncrasies of the product that a true arbitrageur cherishes. After all, attention to detail and single-minded research can give the superior arbitrageur a competitive advantage. Any time you can increase return, legally and organically, opportunity beckons.
Next time, we visit the short sale, the magic sauce to market-neutral investing, as we begin to describe “the hedge.”
The Death of Sam Wo
Sam Wo’s in San Francisco’s Chinatown, closed recently due to health and safety code violations. The codes were enforced on this San Francisco institution in the name of progress. We will not speculate as to the severity of the issues; we have no right or experience. However, a neighborhood icon has unfortunately closed. The following excerpt from the San Francisco Chronicle sums it up:
“Sam Wo restaurant in San Francisco’s Chinatown closed its doors Friday [April 20] for violating a litany of fire and health codes, but the story’s not over yet for one of the city’s most storied hole-in-the-wall eateries.
“Owners of the 100-year-old Washington Street restaurant famous for its no-frills, late-night food and its you-get-what-you-get service have the chance to plead their case Tuesday morning [April 24] at a hearing with the city’s Public Health Department, said department spokeswoman Eileen Shields.
“Owner David Ho’s daughter, Julie, told The Chronicle that they plan to attend the meeting.
“‘This restaurant is my life,’ she said Friday, overcome with emotion. ‘We’re definitely closing for the weekend, but beyond that nothing is definite.’”
Ho, whose father was home resting after a long day, said lines to get in one last meal at the restaurant were wrapped around the block for most of the day Friday. While they’ll certainly have the support to stay openâ€”the restaurant gained renown in the city thanks to the storytelling of Armistead Maupin, Herb Caen and even Conan O’Brienâ€”it will be an uphill battle, Shields said.”
Sad it is, because Wo’s was one of those places that “oozes” character and serves as a canvas for lasting memories. Every city has them and they are the antithesis to the Olive Gardens and Ruby Tuesdays of the world. With apologies to John Donne, every place like this that dies diminishes me. Let’s hope the San Francisco civic leaders find a way to reopen Sam Wo. We need to preserve our neighborhood “joints,” so to speak. Without them, our descendants lose a link to the past and we will all become homogenized without ever realizing it.
Lastly, PBS’s Frontline has been running a series entitled “Money, Power and Wall Street.” Frontline documents the global financial crisis. It is illuminating, insightful and fascinating. I urge every reader to watch it. Bravo, PBS!
Until the next time â€¦ The Thoughtful Arbitrageur.
Edward Strafaci is not an investment adviser. Nothing he writes should be construed as investment advice or an endorsement of any particular security. From time to time, a family trust with which he is associated may have positions in the securities he writes about. When it does, he will tell you. What he writes is meant to inform and in some cases to entertain and amuse. HedgeWorld’s Alternative Reality is not an investment advisory site. As a general rule you should not take investment advice from blogs, anyway. Consult a financial professional for investment advice, not a blog.