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Convertible arbitrage is the hedge fund trade of the moment, with top-ranking returns of 12.58 percent so far this year, but there could be more to come.

The strategy, in which managers usually buy a convertible bond and short the underlying stock, is proving particularly profitable because the bonds are rebounding from the battering they took last year. The strategy lost 31.59 percent, the second-worst performing strategy, in 2008 as funds scrambled to sell their positions in what had become a crowded trade.

Such is the scale of the rebound in convertible bonds now that simply buying the convertible, without shorting the underlying stock, is proving very profitable.

Paul Compton, head of product management at software group Sungard’s alternatives business, thinks the outlook is positive.

“In 2008, valuations in the market were so depressed, not just due to credit spreads but also prime brokers withdrawing leverage. Investors got seriously cold feet and redeemed. More than half the convertibles universe was owned by convertible arbitrage funds and the market couldn’t really absorb that,” he said.

“My gut feeling is there’s more to come, now that the market is starting to behave a bit more normally. It could be the stand-out performer of 2009 because of the depressed state of valuations in December, although if there’s a stunning recovery in the stock market it will probably underperform.

“What is really needed is to lock in investors and not face redemptions. We’ve seen new funds launch and distressed credit funds getting into convertible arbitrage.”