For UBS marketing purposes

Convertible arbitrage as a hedge fund strategy should continue to work well in 2021. (Keystone)

Investment strategies Why convertible arbitrage makes sense in 2021

19 January 2021, 8:52 pm CET, written by UBS Editorial Team

The current market environment is conducive for convertible arbitrage hedge funds with elevated new issuance, attractive equity volatility levels and convertible valuations all likely to support performance in 2021. Investors should consider allocating to the strategy within a diversified hedge fund portfolio.

The global coronavirus pandemic resulted in significant equity market drawdowns in March last year, followed by an almost unparalleled recovery over the next few months. On balance, 2020 was a good year for hedge funds focusing on convertible arbitrage strategies which returned 12.1% for the year, according to HFR data. We believe that all drivers remain in place for a solid performance in 2021. And while current market conditions resemble those after the great financial crisis, convertible arbitrage today is a far less crowded strategy with more moderate leverage levels. The market structure is also more balanced between hedge funds and long only funds, and has after a long period of outflows, recently witnessed renewed investor interest. So we believe there are a number of reasons why convertible arbitrage remains attractive for investors in 2021 based on the following assumptions: Convertible arbitrage traditionally performs well in recovery phases. Historically, convertible arbitrage funds have generated their best returns during periods of economic recovery and expansion. Improving risk sentiment, tightening credit spreads, and attractively priced new issues are key contributors to returns in such periods. We think such conditions are still in place in 2021 and thus view the current environment as supportive of convertible arbitrage performance. Valuations still look appealing. Despite last year's rally, convertible bond valuations are still attractive relative to model implied fair value. Managers should benefit from a normalization of the valuation gap. Single name volatility also remains elevated, suggesting that gamma trading opportunities continue to be rewarding. Importantly, convertible arbitrageurs are no one-trick pony. They can also seek exposure to more event driven situations including distressed opportunities, and even SPACS trading. For UBS marketing purposes

We see plentiful alpha opportunities in 2021. According to BofA, global new convertible issuance volume may surpass the USD 100bn mark once again. Key drivers bolstering this trend include, low interest rates, continued demand for cash and/or rescue financing and more broadly elevated corporate activity. For managers, this means 1) opportunities to harvest discounts on the primary market and 2) technical trading opportunities in the secondary market as increased supply typically causes long-only funds to rotate into new paper.

Risks to this strategy include the fact that these funds are levered, typically about two to three times, and that they are exposed to credit, issuer, liquidity, FX and corporate action risks. Convertible arbitrage also tends to focus on tech, healthcare and consumer discretionary sectors, which can be a headwind during a sector/factor rotation.

However, a strict selection process combined with a diversified investment approach focusing on disciplined, nimble and seasoned managers can help mitigate some of these risks. When observing all of these points, we believe the current environment remains conducive for convertible arbitrage and that the strategy makes sense in a diversified hedge fund portfolio. For more on this, please refer to our "Q&A: Is convertible arbitrage still attractive". For more on how to hunt for yield, please click here.

Important information: https://www.ubs.com/global/en/wealth-management/our-approach/marketnews/disclaimer.html The product documentation, i.e. the prospectus and/or the key information document (KID), if any, may be available upon request at UBS Switzerland AG, Bahnhofstrasse 45, 8001 Zurich/Switzerland. Before investing in a product please read the latest prospectus and key information document (KID) carefully and thoroughly. © 2021 UBS Switzerland AG. The key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved.