Pain in the market for convertible bonds is crippling big hedge funds and cutting off a key avenue of financing for many companies.
This market, which has long welcomed businesses struggling to raise cash, is the latest to suffer from too much borrowing and faulty hedges, which came unwound in the recent turmoil.
Overall, the $200 billion convertible-bond market has lost 36% so far this year, a bit more than the stock market, according to Merrill Lynch. But the average convertible-bond hedge fund has lost about 50% in that time, including a 35% plunge in October, according to Hedge Fund Research Inc.
Buying and selling convertible bonds is a bread-and-butter trade for many hedge funds, and the market's decline has hit some of the biggest ones. Among them is Highbridge Capital Management, which at one point managed as much as $34 billion. The firm is down 22% so far this year, its first down year, in large part because of convertible losses.
About a quarter of the 35% or so losses that Citadel Investment Group has suffered so far this year are from convertible bonds, according to people close to the matter. Jabre Capital Partners, a convert specialist that began the year managing $3 billion, has seen losses of more than 15% this year and recently laid off about 15% of its employees, according to investors.
Convertible bonds are part stocks, part bonds. They act like bonds and usually pay interest. But, as an added kicker, they give holders the right to convert the securities into stocks at a certain price. The market is normally less volatile than stocks, but the securities can have the same upside if a company rebounds.
Lately, convertible bonds have been falling amid worries about the health of companies that sold them. And stock prices of companies that sold convertible bonds have fallen so far that most would have to at least double for the conversion-option to have any value.
Perhaps more important, hedge funds have been selling convertible bonds to raise cash to meet redemption requests, putting further pressure on prices, while Wall Street banks also are unloading the securities as they reduce their own appetite for risk.
Hedge funds, which at times owned as much as 70% of the outstanding convertible bonds, traditionally try to protect themselves by shorting, or borrowing and selling, shares of the same companies, profiting from the difference in the movement of the securities. But some funds did a poor job hedging themselves, or didn't do much hedging at all, figuring the market wouldn't tumble, traders say.
At the same time, some funds focused on convertibles borrowed as much as $5 for each $1 of equity in recent years, leverage that for some has turned small losses into huge ones. A 10% loss can become a 60% drop if a firm's borrowings amounted to five times its capital.
Now prime brokers are either cutting off hedge-fund clients, raising borrowing rates or forcing them to produce more collateral to back the borrowed money.
Convertible bonds have long been a crucial means of financing for companies facing challenges that make a stock or bond sale too expensive. But just $57 billion has been raised in the convertible market so far this year.
Now some specialists, such as Advent Capital, a $4 billion investment firm, are launching convertible-bond "recovery" funds. "The market is the cheapest it's been in 30 years," says Odell Lambroza, a partner at Advent Capital. The market is up 10% in the past three days, in part because some hedge funds have stopped selling.
Write to Gregory Zuckerman at gregory.zuckerman@wsj.com
