Odell Lambroza - The Resurgence of Convertible Bond Arbitrage

00:00:09 [Vincent Weber]
Hello, everyone. I'm Vincent Weber, and this is Resonanz Spotlight, the podcast where we explore investment strategies, learn the stories behind them, and meet the experts and creatives. Once upon a time, in the land of hedge funds, there was a strategy known as convertible bond arbitrage, a strategy that ruled them all. Only the most skilled managers Masters of volatility trading, credit analysis, stock selection, and macro trends could harness its power to deliver strong risk-adjusted returns year after year. But one day, dark clouds of low interest rates and low volatility covered the market, shrinking the opportunities for this strategy. To make matters worse, the flow of new convertible bonds slowed to a trigger. Many of the strategy's masters sought new ventures in credit investing, special situations, or long-shot equity.
Yet, a few remained loyal, believing in the strategy's long-term potential. They adapted to the storm, confident that brighter days will return. Today, we are joined by one such believer, Odin Lambrosa, Chief Investment Strategist and Co-Portfolio Manager of the Advent Global Partners and Advent Vega Strategies. With years of experience in convertible securities, Odell has seen the strategy evolve through markets ups and downs. Welcome to the show, Odell.
00:01:32 [Odell Lambroza]
Good afternoon. Thank you for having me on today.
00:01:34 [Vincent Weber]
Odell, let's start with the basics. So for a listener who might not be familiar, could you explain what convertible bond arbitrage is and how it works?
00:01:44 [Odell Lambroza]
Absolutely. Convertible bond arbitrage is actually a very simple strategy. We generally go long a convertible bond and we short the underlying equity to hedge out the risk or to create a hedge portfolio. And so in effect, what you've created is a package. As stocks move around, which represent volatility, we're able to trade the different movements and to generate a absolute return via the strategy. And so. Convertible arbitrage is usually considered an absolute return strategy because we're hedged and we're looking to generate profits for investors through the trading of volatility.
00:02:27 [Vincent Weber]
So now that we have an understanding of the strategy, can you tell us which companies and sector typically issue convertible bonds?
00:02:36 [Odell Lambroza]
Absolutely. I've had the good fortune of being in the convertible market for 25 plus years. And through that, you can imagine we've seen many cycles and many types of companies come to market. Generally, the companies that have come to the convertible market are sort of their growth companies, which would encompass technology companies, as well as healthcare and biotech. Given the revolution in computing, We've seen a lot of cloud computing companies and even Bitcoin companies come to market. And I give you names that over time, some of the issuers that have come have been, names like NVIDIA had convertibles and advanced micro devices. So even Microsoft. So, over time, we've seen a variation of the type of companies.
And again, it depends where we are in a cycle, but usually they're really exciting growth sectors that are involved.
00:03:33 [Vincent Weber]
Right. Liquidity is often a concern for investors. What is the underlying liquidity of convertible and how does it affect your strategy?
00:03:45 [Odell Lambroza]
Absolutely. And it is one of the key topics that come up when we deal with investors. And one of the things that's interesting is that the liquidity in the convertible bond market is actually higher than the high yield market. Given that these are big, most of the market is by big broad issuers issuing the convertible bonds, names like Tesla or Uber even, you're finding liquidity is very robust in the marketplace. And so what we consider is that today, as we sit here today, we consider the market extraordinarily liquid, probably on the top end over the last 25 years of liquidity.
00:04:28 [Vincent Weber]
And since the great financial crisis, they're having a major shift in market. So how has convertible bonds arbitrage evolved since that time?
00:04:39 [Odell Lambroza]
Absolutely. I think for most, and Vincent, you appreciate this, for most managers and investors, the GFC or the global financial crisis as we refer to it as, had a profound change in the way managers approach things. However, convertible arbitrage hasn't changed that much. The premise of buying a convertible bond and shorting the underlying equity is routed in a lot of quantitative theories, Black-Scholes theories, and it hasn't changed that much, actually. It's a strategy that performed extraordinarily well into the GFC for decades before that and continues to perform well. I would say the only variation that's come out of it is that hedge funds. have had greater opportunities to generate returns because what the global financial crisis did do is remove a tremendous amount of competition.
And so, I think it was at the benefit of the strategy, but the essence of the strategy hasn't changed that much, Vincent.
00:05:39 [Vincent Weber]
Okay, you briefly mentioned headphones. So what about market participants in general? So have you noticed any change in the type of investor or institution involved in this space? compared to the pre-GFC area?
00:05:55 [Odell Lambroza]
Absolutely. One of the effects of the GFC clearly was a movement in the market towards more what we consider long-only or institutional real. money not hedge fund related money and so the market now is on a percentage basis if you look at every day's trading or ownership most of the market or or a larger percentage of the market is held by outright investors prior to the global financial crisis going into it the majority or about i think the number from barclays came out about 70 percent of the money in the market was with hedge funds now it's been reversed where long-only managers are more prevalent and and Just to explain that for a second, the benefit is that as a hedge fund, I'm able to trade and generate returns generally when you have more inefficiencies,
correct? And long-only managers, institutional managers, create the inefficiencies we need. So it's, again, a positive development since the GFC.
00:06:56 [Vincent Weber]
So you share a lot already, but before we continue. I'd love for our listener to hear more about your personal journey. So you had a long career in the world of convertibles, derivatives. So could you share with us some of the biggest challenges you faced during your investing career and how you managed to overcome?
00:07:16 [Odell Lambroza]
Absolutely. I had the good fortune of starting in derivatives and convertible bonds out of university. I was an engineer, so it drew me immediately, Vincent, because it's a Bit of a quantitative field based on models and theories of options analysis, derivatives and convertibles. And so, and convertibles in a convertible bond, you have the volatility aspect, you have a bond with a credit and interest rate aspect. So it brought a lot of things together. I was on the sell side. I started my career at a firm formerly known as Merrill Lynch. I think, it's been changed now. Bank of America now securities. And I grew up. Eventually running a trading desk. I joined Advent 2001 to help build up the convertible arbitrage hedge fund. And I think you mentioned challenges.
And clearly, anyone you can appreciate that's been in this field for 15 years or plus, you've lived through a global financial crisis. You lived through COVID, which was its own crisis. And through it, we've- garnered I think a lot of experience I think the biggest challenge is clearly through those times was managing I think the risk through these portfolios we've seen a lot of discontinuous markets and so on but again I think even going back to the dot-com bubble if we remember the dot-com bubble there's a certain there's a certain thread of of logic that goes through this and how we how generally convertible arms convertible securities behave through that funny enough some of the more challenging times are actually when the markets have very little volatility because ironically we make returns not us convertible
arm as a strategy make returns when volatility is robust. And so when there's no volatility, it becomes challenging as well. So it's ironic in a way what creates challenges for managers.
00:09:18 [Vincent Weber]
That's interesting. So coming back to our main theme, so what are today the key drivers of return in convertible bonds? So what factors should investors be keeping an eye on?
00:09:32 [Odell Lambroza]
Absolutely. When you create And you look at your performance in convertible arbitrage, there's certain drivers. The first is we own a portfolio of fixed income securities, i.e. convertible bonds. And so you get coupon, you get an interest payment from that, right? So one is income. The second thing is as we short stocks against our bonds, we get something called a short rebate, right? Which is you get income off our short. So that's a second source of revenue. And the third source is what we consider, and some may know it as volatility trading or gamma trading, is we make money as we set up these arbitrage pairs and we trade the stock. As volatility moves in and we're able to hedge and re-hedge, we generate a return.
And so there's many drivers of returns in convertible arbitrage, and that's one of the benefits of the strategy. sort of talk about is that there's not just one sole source. As if you're an equity manager, you need your stock to go up, let's say, right? If you're a long-only manager. For us, we have many different levers to generate performance. And, that's one of the benefits and why we consider this sort of an all, market always has considered this as an all-weather strategy.
00:10:50 [Vincent Weber]
No, every strategy comes with its own risks. So what do you consider the major risk? with this strategy? The one I should keep an eye on as an investor?
00:11:01 [Odell Lambroza]
Absolutely. I mean, like many other strategies, we're prone and we're subject to technicals. I'll give you an example. During the COVID crisis or the global financial crisis, you see lots of selling pressure from ETFs and mutual funds. And that creates a dispersion or or a movement a part of these spreads that we consider so we have technical sell-offs which create cheapening in the market i.e the spreads move out wider than anticipated that usually over time corrects itself usually but that's something that needs to be considered and that there's also the the idea of periods of very low volatility right there is the risk that if the realized volatility in the market is extremely low for six months a year, it's harder to generate that profits from gamma trading.
So, those are, I would say, two generally of the biggest concerns we have in there. And, as managers, we always learn how to manage around that or hopefully, do prudent risk management as a group. But I think those are kind of things to keep in mind as you consider the strategy.
00:12:15 [Vincent Weber]
So finally, could you share with us in which market environment convertible bond arbitrage tends to perform best? And where do you see this strategy going in the future?
00:12:26 [Odell Lambroza]
Absolutely. First thing, where rates are medium to higher, such as now, we consider is very good for the strategy. Right. Higher interest rates allow companies to consider issuing convertible bonds as opposed to other parts of other fixed income instruments they can issue. So when rates went up as rates for the last two years, it's actually been a positive for the convertible market because we're seeing a pickup in new issuance. That's first. Second, levels of moderate. or heightened volatility on the horizon is very positive. I mean, we live in a world right now of economic uncertainty. We have an election in the U.S., but we also have elections overseas. We have geopolitics weighing in, and it's creating volatility that looks to be continuing.
And that's really positive because that source of drive or one of these sources of return drivers we talk about, which is volatility. is here and we think it'll be here for a long time and so i would say medium to higher rates and volatility based on economic uncertainty are wonderful wonderful variables that allow us and has for the convertible arm to perform well we believe oh that's great so thank you thank you for providing such valuable insight today
00:13:52 [Vincent Weber]
It's been really fascinating to learn about how convertible bond arbitrage has adapted and continues to hold very strong potential into this investment landscape. And thank you to our listeners for tuning into this episode of Resonanz Spotlight. If you enjoyed today's conversation, please subscribe, share, and leave a review. Until next time, keep exploring, keep learning, and stay tuned for more insight on the world of investment strategy.