Convertible bonds are trading at or near all-time lows after a year in which hedge funds and investment banks have dumped holdings to cut their leverage and bolster capital.
Once adjusted for the value of the bond’s built-in option to convert into shares, convertibles – a popular way for cash-strapped companies to raise money – are cheaper than at the worst point reached in 2002 at the bottom of the last cycle.
But the risk of further unwinding of hedge fund holdings has left many traders unwilling to call the bottom of the market, even as mutual funds appear to be returning.
“We all came to the conclusion a few months ago that convertibles had got ridiculously cheap,” says one executive at a big convertibles hedge fund. “And they’ve just got cheaper. But the downside from here is extremely limited.”
The convertibles market has been battered by forces familiar to investors everywhere: rising risk aversion pushing up credit spreads and pushing down equities.
But converts are also particularly exposed to the travails of the hedge funds, as the market is dominated by hedge funds and their close cousins, the investment banks’ proprietary trading desks.
As banks have faced higher funding costs and demands to reduce their risk, they have reacted by closing or shrinking proprietary trading desks, and by cutting back lending to hedge funds or charging more for it – prompting the funds to sell assets to reduce leverage.
There have also been a few forced sales, as hedge funds involved in fixed-income arbitrage – known as “relative value” traders – were hit by volatility and had to raise cash in a hurry.
Liquidity-driven sales have led to some odd mis-pricing in a market normally full of arbitrageurs ready to search out and eliminate any anomaly.
Tracy Maitland, founder and president of Advent Capital Management, a New York hedge fund and long-only manager specialising in convertibles, says some of these are just strange.
He cites a Merrill Lynch convertible trading more cheaply than an equivalent plain-vanilla corporate bond issued by the bank: in effect giving the investor – free of charge – a valuable option to convert into equity.
“Dislocation in the market has presented some real opportunities that you haven’t seen in a long while,” he says.
Other more liquid issues showing “negative basis” – where investors can hedge all their credit risk using derivatives and make a profit – include several US real estate investment trusts, according to another hedge fund manager.
For many hedge funds the arrival of this dislocation has caused serious pain.
Convertible arbitrage, a long-standing hedge fund strategy, can be a bet on a credit position, on the potential equity exposure of the bond or, through the valuation of the option, a bet on volatility.
This year, all three possibilities have been hit as credit and equity markets tumbled, and, thanks to deleveraging, the volatility implied by convertible pricing – based on the valuation of options – has actually dropped, even as market volatility has soared.
“It is the cost and availability of leverage that is driving the market,” says David Rogers, a senior portfolio manager at London hedge fund CQS. “We are getting to valuation levels that look attractive.”
As a result, many convertible specialist hedge funds have lost out.
Ferox, a large London fund, is one. It was down about 14 per cent in the year to mid-August, according to investors, while the sector is among the worst-performing.
Chicago-based Hedge Fund Research estimates convertible arbitrageurs are down 8.2 per cent for the year, behind only equity long/short funds and emerging markets. CQS and Advent are both off 2 per cent or a little more in their main convertible hedge funds.
Arshad Ghafur, European head of equity-linked solutions at Lehman Brothers in London, says: “The only way the arbitrage works is that the coupon either pays or subsidises the funding cost. So as the funding cost rises, the required yield on the instrument goes up as well.”
However, the price falls are attracting long-only buyers, such as mutual funds, which had pulled back from the market in recent years. There have also been some corporate buy-backs of bonds, with Macquarie Communications Infrastructure Group, an Australian investment fund, buying back $320m-worth last week.
The flip-side of the price falls is that new issuers are avoiding the market if they possibly can. While the first five months of the year saw strong issuance of new bonds, it has since dried up.
There could be more to come as companies facing a cash crunch are forced to raise money even at unpalatable levels, though. Mr Ghafur says there is a strong pipeline of deals to come later this year, adding: “If people are still reluctant to issue equity for funding, the convertibles market is the only one that is open at a reasonable cost to issuers.”
The big question facing the market is whether the selling pressure which the hedge fund and prop desks are under is coming to an end.
One hedge fund manager estimates leverage has fallen from four times capital to two times, a low level for arbitrageurs.
But, as the end of the year approaches, many hedge funds are worried about a new source of pressure: withdrawals by investors who need cash or no longer like the industry.
Many underperforming funds have already been hit hard by such redemptions; if that becomes more widespread, another wave of selling could hurt the market as managers rush to raise cash to repay clients.
