One stylized way to look at capital structures is that the most senior creditors are entitled to the first dollar, equity holders get the last dollar after all obligations are satisfied, and that there are intermediate securities—preferred stock and convertibles—that combine features of both. Preferreds used to be much more common than they are today—you'd have a fixed dividend, but the company would follow a mechanical payout rule for whether or not you got your money. So a company might issue $1m in bonds yielding 6%, $1m in preferreds yielding 8%, and $1m in common. They had to pay $60k to bondholders regardless, preferred shareholders would get the next $80k (and if there wasn't $80k to go around, that dividend would accumulate until it was paid off), and common shareholders would get an uncertain dividend that could be revoked at any time. Convertible bonds (or convertible preferred) are just another wrinkle on that middle-tier structure; a convertible bond would generally pay a lower rate than a bond, but could be converted into stock at some fixed exchange rate (maybe when the stock's at $20, you could buy a $1,000 convertible bond that could be exchanged for shares at $25 and paid you a little interest along the way).

So you'd think that companies would turn to equity markets when their prospects were most uncertain, then convertible bonds as their prospects firmed up but investors still wanted a kicker if everything worked out, and then they'd mature into the kind of business that can issue a 20-year bond because it's pretty clear that they'd be around in twenty years to pay it off.

In practice, that's not how it works, because a convertible bond is really an option with a small fixed-income component—but plenty of the scenarios where the convertibility portion doesn't pay off are ones where there are credit problems, too. And since the value of an option is tied to volatility, you end up with an odd hierarchy:

• Growth gets funded with equity when there's uncertainty and illiquidity.

• Certainty gets converted into higher returns through leverage—you can get the variance in profits you want by adjusting leverage.¹

• Uncertainty plus liquidity encourages companies to sell convertible debt, mostly to hedge funds (and cross over investors, in some very interesting cases: Silver Lake, TCV) that specialize in it.

The presence of those convertible debt funds is part of a weird historical contingency: convertible bonds got popular in part because they feel like a compromise, and in part because it's easy to confuse people with them. But over time, market participants got more and more confident that they could price them effectively. Ed Thorp wrote a book on this in 1967, some smart people read it, other smart people tried to think step-by-step about how to value the different parts of the payoff and stumbled on good ways to hedge it, and eventually a cottage industry of convertible arbitrage arose.

The way a typical trade worked was that someone would identify a convertible bond that looked mispriced—it works in either direction, but historically investors underpriced the option and so the first leg of the trade was to buy the convert. Then they'd short enough common to hedge out their immediate exposure (so if you buy a convertible bond for $1,000, whose value rises ~0.25% for every 1% the common rises, you short about $250 of the common).² Hedge the impact of stock price fluctuations on the convertible bond, and you've isolated the "everything else" that drives the value of an option. If you run the trade in this fairly naïve way, you end up long volatility by way of the option, but also short volatility by way of the fixed-income piece.

When this business was just getting started, it was at the ideal intersection for self-directed traders: you didn't need to do anything special to get access to the relevant asset classes, you just needed to do some math (either plugging numbers into somebody else's formula or figuring things out on your own), and you had a nice little arbitrage that, for a while, printed money. The trade got crowded, and, as it did, some nuances started to show up. A trader doing convertible arb is still taking on some correlated risk, especially if there are other levered traders doing it, too. Ed Thorp, Ken Griffin, Paul Singer, and Michael Hintze all started now-diversified vehicles whose original business was convertible arb, and it must have been a uniquely insightful business because there are roughly three directions you can go once you have a 101-level volatility-harvesting strategy³ :

1. Maybe you notice that you lose big when there's some fundamental reason for volatility to be priced the way it is, so you expand into discretionary trading.

2. Maybe you notice that weird quirks in the bonds' terms can have a big, unpleasant impact, and you decide that the world of distressed debt and activist investing is a natural way to harvest alpha from being picky about the details of agreements.

3. Or maybe you get tired of people intruding into your ivory tower to remind you that the time series data attached to alphanumeric tickers actually represents, in some abstract sense, an effort to value real-world businesses, and that the collision between models and economic reality keeps costing you money. If you're Ed Thorp, at some point you apparently throw up your hands and say "Screw this! I'm going to find similar systematic strategies and run them until I'm so diversified that no real-world event can throw things off" and then invent statistical arbitrage.

The strategy still exists, though it's more crowded and less fun than it used to be. But now it serves a social function: when traders get too excited about batting some stock around, the company can get a very good deal by issuing convertible bonds. These bonds will basically all get sold to convertible bond funds, who will all do roughly the same thing—short some stock to be delta-neutral, and adjust those hedges over time. To stay delta-neutral if you own a call option, you short more as it goes up (it's further in-the-money and more sensitive to stock price movements) and vice-versa. In other words, issuing a convertible bond to take advantage of high volatility basically means paying convertible arbs a commission for reducing that volatility to a more sensible level.

So we have an investment ecosystem where, when a company's share price bounces around more than fundamentals justify, management can directly convert this into funding, and do so in a way that systematically pushes against exactly those moves. This is just one of those facts of corporate finance, in the same way that a company with a really cheap stock will probably buy some back and a company with an expensive stock will restore the equilibrium by using that stock as currency for an acquisition. The main difference is that there's a lot more room for value-destructive behavior, and the investor audience that makes things really volatile is a group of retail investors who don't necessarily realize that they're making bets with negative edge.

The Diff has talked a bit about converts and a lot about volatility in general:

• We've looked at why arbitrage in general was a great training ground for investors.

• When companies court retail investors, they sometimes engage in a kind of corporate populism.

• The terms of a venture investment can be tweaked to give both investor and recipient better incentives.

• The concept of volatility being shifted around rather than created or destroyed has interesting implications when you apply it to the real economy ($).

Join the discussion!

1  This works even for negative leverage. If there's some business with high fixed costs and variable revenue, such that it will predictably lose money in bad years, it might be optimal to raise more cash than is needed to run the business, and just keep it on the balance sheet in order to ride out downturns. Usually, this is difficult because the big source of fixed costs is owning some long-lived asset that steadily depreciates, but there are exceptions: in the spring of 2020, Uber did not trim the size of its network by 90% even though peak-to-trough demand probably declined by more than that—they made the bet that it's better to burn money on lots of idle people than to have to staff up customer support, operations, and their driver fleet as soon as demand came back. They didn't explicitly plan for a global pandemic that would temporarily shut down the economy, but they did have ~$11bn in cash on hand coming into Covid, or about six months of expenses, mostly because they'd just done an IPO.

2  Another reason the long convert/short common trade worked was that shorting the convertible bond was hard. You'd have to find someone who owned it and wanted to lend it to you. Thorp's book talks about hounding the stock loan departments at different banks, perhaps getting them to hound stock loan departments where their friends work, until you get the borrow.

3  As a general matter, it can be lucrative to exploit lots of small and uniformed counterparties, but it can be even more lucrative to exploit a big, sophisticated investor who's making one specific mistake that you yourself recently stopped making. Push prices a tiny bit outside what they think the equilibrium is, and they'll give you a lot of liquidity! So whenever there's a strategy that's mostly implemented by professionals, as it gets crowded there's more of an opportunity to systematically identify which risks get rounded to zero in most people's models, and to bet big on them.