Rising rates, zero-coupon issuance and a broad sector universe have brought convertible arbitrage back

Before Citadel turned into a global juggernaut, Ken Griffin made his name trading convertible bonds from his Harvard bedroom. Griffin exploited an inefficiency, discovering that bonds didn’t seem to be priced consistently with stocks. This opportunity morphed into a durable and return-yielding strategy, and convertible bond arbitrage became the bedrock on which Citadel was built.

Griffin became its main proprietor, at a time when convertible bonds were an area of huge untapped potential. Japan in particular was worth north of $350bn, an astronomical figure given the hedge fund industry was still in its relative infancy. One character who sought to exploit this vast opportunity was Chris McGuire. After working for several major banks in the sell-side division, McGuire launched his fund, Phalanx Capital Management, in 2004, trading convertible bond, volatility, and capital structure arbitrage.

For McGuire, the opportunity set in Japan has always been unique: “The market oscillated and experienced significant volatility. Japan was a market characterised by cash-rich companies trading below book value, with little incentive to invest that cash or change how they operated.” During this period, the investment universe was close to 1,000 different issues, with a market not defined by high levels of tech concentration; companies of almost every industry were issuing convertible bonds.

As the 00s grew older, convertible bond arbitrage became harder for hedge funds to justify. The GFC meant pressure was applied to funds as they faced redemption requests and a broader deleveraging took place across the industry. Short-selling restrictions were put in place, a constraint that meant convertible bond arbitrage strategies became redundant. The BOJ’s easing and negative rates from 2016 further compounded the dwindling appeal of the strategy. A cheap coupon in exchange for an equity option was no longer attractive, because straight debt was nearly free.

The dwindling opportunity set eventually led McGuire to vacate the investment scene altogether, before returning in a new guise with Eagles View Japan Management a couple of years ago. Convertible bonds are now back in fashion. A soaring equity market, driven by corporate capital being deployed strategically and aggressively, prompted the BOJ into action to help stem the growing inflationary tide. Moreover, with borrowing costs continuing to rise significantly, companies can now issue zero-coupon convertible bonds. McGuire notes that despite the high equity market concentration, convertible bonds are not limited to one single sector, with the fund holding a broad-based exposure: “Companies across several industries are now accustomed to issuing convertible debt; our holdings include airlines, railways, steel companies and even a company that cleans up space debris.”

Another appealing feature of the Japanese market is the credit quality it possesses. To exploit these opportunities, McGuire uses asset swap strategies; “this allows you to strip away the fixed-income component and retain exposure to the equity option.” However, credit quality being attractive can place a natural barrier on returns, with fewer high-yield and high-volatility options that could be significantly profit-rich.

McGuire is keen to point out Japan’s continuing appeal and the opportunities it offers, comparable to the largest Western economies, despite growing economic development across APAC. “China is a huge, developing economy, but its markets do not always offer the same degree of correlation or accessible risk liquidity for global investors.” This is not a consensus broadly held - China is continuously heralded for its astronomical and hegemonic economic growth, while South Korea and Taiwan have been at the epicentre of the AI buildout, reaping huge rewards for those funds with exposure.

Japanese equities have become a forgotten story - despite the Nikkei 225 being up close to 115% in the past five years. McGuire sees many mistakes from investors, who underappreciate the unique makeup of the economy: “Many believe they trade in the same way as Western markets. Companies and markets behave differently in Japan.” The recent yen intervention by Treasury Secretary Scott Bessent was a prime example of this. Investors had built short positions in the currency because they believed Japan was lagging behind other markets. When fundamentally, the BOJ position and market behaviour in Japan are because of the unique relationship between public and private governance.

McGuire understands this and is bolstered by having years of experience to hone his approach. In this current environment, the Japanese convertible bond market size is now a fraction of the US, at $20bn compared to $400bn, with even Taiwan and Hong Kong exceeding $100bn. “The small size of the market works in our favour and makes it hard for very large hedge funds, who want to invest tens of billions of dollars to generate returns; there simply isn’t the capacity.” The firm returned 24% last year and is up more than 20% so far this year. Re-energised after several years out of the spotlight, McGuire is making the most of the convertible bond arbitrage opportunity in Japan.