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  • Strategy involves buying convertibles and selling shares short
  • Gains on short position more than offset drop in bond price

PDD Holdings Inc.’s record stock slide delivered gains to a popular hedge-fund strategy that seizes on the disconnect between the stock and corporate-bond markets.

The tactic is centered on convertible bonds, a type of debt that can be redeemed for shares under certain circumstances. It involves buying the debt — which gives the owner the equivalent of a call option allowing them to buy shares at the conversion price — and selling the company’s shares short as a hedge.

That payoff was in evidence on Monday, when the Chinese e-commerce company’s US-traded shares plunged 29%, the worst day ever, after it reported quarterly revenue that missed estimates and warned that sales growth will slow. That was nearly five times the 6% drop in the price of PDD’s convertible bond expiring in 2025.

The convertible arbitrage trade isn’t usually set up on a one-to-one basis and depends on what’s known as delta hedging, a process that requires market participants to balance their short and long positions to remain neutral. But outsized gains on the short position meant the tactic paid off Monday.

One back-of-the-envelope tally shows the trade could have produced a 2.4% gain on Monday on an unleveraged basis, according to three traders. Since hedge funds typically borrowed funds to build the positions, their return ranged from 5% to 10% that day, one of them added.

The strategy has become popular with hedge funds this year as companies increase sales of convertible debt, which typically cost borrowers less than conventional bonds. Chinese technology companies including Alibaba Group Holding, JD.com Inc. and Lenovo Group Ltd. have all sold such securities this year.

Written by:  @Bloomberg