Convertible Bonds and Hedge Funds

Abstract

The Wall Street Journal has reported that hedge funds might make up as much as 70% of the demand for convertible bonds. Most research on convertible bonds concentrates on the basic characteristics of the bonds, rather than their place as a component of a common stock portfolio. The hedge fund buyer of a convertible can hedge by selling short a non-convertible bond and selling a call option on the stock, or selling short some number of shares of the stock. The primary objective of the hedge fund is to realize gains, whether the stock price goes up or down. This is likely not to be possible for all possible prices. A hedge fund is an interesting investment alternative as a hedge of a common stock portfolio, when the hedge fund gains significantly with large stock price drops.