One of the best risk-adjusted strategies during the 2000 to 2002 bear market, convertible bond arbitrage suffered its own version of bear market in 2004 and 2005 after a boom in new issuance resulting in a saturated market. But now, the sector offers another round of opportunities for investors seeking a hedge against downside stock market volatility in 2007.

Convertible bond arbitrage typically involves owning the underlying bonds or convertible bond of a publicly-traded company while simultaneously shorting the same company's common stock, or sometimes, another company's shares. In text-book market theory, the common stock price declines sharply amid an extended market decline (similar to 2000 to 2002 or a bear market) while the underlying convertible increases in value. It's a "win-win" strategy for the investor or hedge fund trader. 

A study compiled by Nomura, the Japanese securities house, shows convertible abritrage strategies returned 9.8% per annum from 1994 to January 2007 versus 7.2% for stocks and 6.3% for bonds. And through February 2007, the Credit Suisse/First Boston Tremont Convertible Hedge Fund Index has gained 2.8% versus -2.2% for the S&P 500 Index as downside market volatility finally makes a long overdue appearance.

What's great about convertible bond arbitrage is the acute negative correlation to common stocks. It's an asset class offering true diversification at a time when market stress is making a comeback after four years of the lowest volatility on record. 

Offshore, accessing convertible bond hedge funds is much easier than in the United States where investors must be accredited. Overseas, several great convertible arbitrage hedge funds funds are still open, starting at just $25,000 for one of the best multi-manager products in this sector -- up 3% in 2007. I'll be plugging that fund in my upcoming issue of Global Mutual Fund Investor, now in its 15th year.