Capital structure arbitrage is an investment strategy that seeks to take advantage of disparities between different equities and debt products issued by the same company. Investors using the strategy will spot such a disparity and then buy or sell assets based on the logical assumption that the market will correct the disparity. Unlike some other forms of arbitrage, capital structure arbitrage does not purport to offer a guaranteed profit.
Arbitrage is simply the practice of taking advantage of disparities. The simplest example is when an asset is traded at different prices on different markets. In theory at least, an investor can take immediate advantage by buying at the lower price and selling at the higher price. In reality, this can be limited by both transaction costs and the possibility of prices changing in the brief period between the two transactions. Another example of arbitrage is when a gambler takes advantage of different bookmakers offering different odds, for example being able to bet on two possible outcomes to an event, both at odds offering a better than 1:1 return.
Capital structure arbitrage applies this philosophy to two different products issued by the same company. In many cases one product will be equity based, such as stock, with the other being debt based, such as bonds. With this type of arbitrage, the idea is not to exploit the disparity on a near-immediate basis, but to take advantage of the fact that the market should move to reduce or remove this disparity in the long run, thus giving the trader a better idea how the asset prices will move in the future.
A good example of this is when news breaks about a company that suggests it is performing particularly badly. In such a situation, both its bond and stock prices will likely fall heavily, but the stock price will likely fall by a greater degree for several reasons: stockholders are at a greater risk of losing out if the company is liquidated as bondholders have a priority claim; dividends will likely be reduced or dropped altogether, whereas annual bond payments are fixed; and the market for stocks is usually more liquid, meaning it reacts to news more dramatically. An investor knowing this can invest to take advantage of his expectation that the stocks will become comparatively much cheaper than the bonds, along with the possibility that the balance between the two will realign later on if the company recovers.
If a company issues two types of bonds, a standard bond and a convertible bond that can be exchanged for company stock, the relationship in the price of the two bonds should be fairly consistent, with the variance depending solely on the current stock price and dividend levels. Somebody using capital structure arbitrage will look to spot when this is not the case and take advantage of his or her confidence that the variance will eventually return to normal levels.