Convertible Security

Some securities do not sit neatly on either side of the debt-equity divide. A convertible security is one of these. It is a hybrid: a convertible debt instrument, or a convertible preference share.

The holder has a choice. They can keep receiving fixed coupons, like an ordinary bond. Or they can convert the instrument into equity shares of the issuing company, at a pre-set price and ratio, on a pre-set date.

Category III AIFs care about convertible securities for a specific reason. The two outcomes — stay as debt, or convert to equity — can be mispriced against each other. That mispricing is exactly what a convertible arbitrage strategy is built to exploit.

The conversion ratio fixes how many equity shares the holder receives for each unit of the convertible security's face value at conversion. A Category III AIF running a convertible arbitrage strategy takes a long position in the convertible security and simultaneously a short position in the same company's equity shares — designed to earn a return that does not depend on which way the share price moves.

If the equity share price falls, the fund profits on its short equity position and continues earning the fixed coupon on the convertible security. If the share price rises, the fund can convert the security into equity and sell the resulting shares at market value, offsetting the loss on the short equity position. The strategy is profitable when the convertible security was mispriced relative to the conversion ratio at entry.

Fund CAS takes a 12% convertible bond position with a face value of Rs 1,00,00,000, at a conversion ratio of 25:1 (25 equity shares per Rs 1,000 face value bond, after a one-year lock-in). It funds this with Rs 20,00,000 of its own capital and Rs 80,00,000 borrowed at 10% p.a., and simultaneously shorts 50,000 equity shares of the same company at Rs 40/share, paying a borrowing fee of Rs 5/share on the short.

Over the year, the equity price rises to Rs 42.50 and the convertible bond price rises to Rs 1,050. The fund converts the bond into 2,50,000 shares (25:1 on Rs 1,00,00,000) and squares off:

Against the fund's own Rs 20,00,000 investment, that is a 27.50% return on investment for the year — earned regardless of which way the share price ultimately moved, because both the long convertible and short equity legs were in place throughout.

Chapter 7 (Category III AIF Investment Strategies and Due Diligence Process), section 7.3 (Convertible Arbitrage Strategy), defines convertible securities and carries this exact worked example (the workbook's "Example 6"). Expect the definition tested directly, and this worked calculation — or a variant of it with different price movements — used to test whether a candidate can trace the income and expense lines through to the final return.

• A convertible security is the instrument; convertible arbitrage is the strategy traded on it. Do not conflate the two — a fund can hold convertible securities without running an arbitrage strategy.
• The conversion ratio is fixed at issuance and does not move with the share price — what moves is whether that fixed ratio is fairly priced against the current market value of the underlying shares.
• Dividends on the short equity leg are a cost, not income, to the fund — the short seller must pay the dividend to the share's lender, which is why "dividend foregone" appears as an expense in the example above.
• Borrowing cost applies to leveraged capital used for the bond purchase; borrowing fee applies to the equity short — two different charges, on two different legs of the trade, easy to swap in an exam question.