How do Related Hedges work?

Question

I'm currently re-reading Benjamin Graham's book, The Intelligent Investor. In it (Chapter 15), Graham mentions some of the undertakings and operations his fund, Graham-Newman Corporation, was involved in. One of them is, as Graham calls them, "Related Hedges". Here is his explanation:

Related Hedges: The purchase of convertible bonds or convertible preferred shares, and the simultaneous sale of the common stock into which they were exchangeable. The position was established at close to a parity basis -i.e., at a small maximum loss if the senior issue had actually to be converted and the operation closed out in that way. But a profit would be made if the common stock fell considerably more than the senior issue, and the position closed out in the market.

From my understanding, Graham is making a profit from the common stock falling far below the senior issues. Here are my questions for "Related Hedges":

How do you make a profit with a "Related Hedge"? Wouldn't senior issues decline in value if the common share price fell?

How do senior convertible preferred shares move in relation to common shares?

Answer 1

In this type of strategy profit is made when the shares go down as your main position is the short trade of the common stock. The convertible instruments will tend to move in about the same direction as the underlying (what it can be converted to) but less violently as they are traded less (lower volatility and lower volume in the market on both sides), however, they are not being used to make a profit so much as to hedge against the stock going up. Since both the bonds and the preference shares are higher on the list to be repaid if the company declares bankruptcy and the bonds pay out a fixed amount of interest as well, both also help protect against problems that may occur with a long position in the common stock.

Essentially the plan with this strategy is to earn fixed income on the bonds whilst the stock price drops and then to sell both the bonds and buy the stock back on the market to cover the short position.

If the prediction that the stock will fall is wrong then you are still earning fixed income on the debt and are able to convert it into stock at the higher price to cover the short sale eliminating, or reducing, the loss made on the short sale.

Effectively the profit here is made on the spread between the price of the bond, accounting for the conversion price, and the price of the stock and that fixed income is less volatile (except usually in the junk market) than stock.