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Battered convertibles lure brave hedge funds

Date: Tuesday, November 11, 2008
Author: Daisy Ku and Laurence Fletcher, Guardian.co.uk

Bolder hedge funds are looking to snap up convertible bonds at bargain prices, returning to an asset class that became a no-go area for them only a short while ago.
The convertible bond market has tumbled 44.5 percent since September, as hedge funds facing a wave of client redemptions paid back bank debt. Many said convertible arbitrage strategies were a thing of the past.
But yields are now reaching all-time highs and are starting to attract the first daring hedge funds back to the investment arena they traditionally dominated.
"You can buy a convertible right now on a 25 percent discount to the same bond issued by the same company," Emmanuel Roman of GLG Partners, one of Europe's biggest hedge funds, told a recent conference.
"You get a 25 percent discount plus a call option. That doesn't make any sense," he said.
The market has recovered by 1.81 percent since the September drop, according to the HFRX convertible arbitrage index.
A move back into convertible bonds holds the promise of big gains for hedge funds that move early, and could ultimately start driving prices up and revive a moribund primary market, making life a bit easier for corporate issuers.
The Hynix Semiconductor convertible, maturing in 2012, for example, traded at a 100 percent annual yield calculated on a basis of exercising the put option on the bond in June 2010. The bonds have since risen, but are still representing a yield to put of 88 percent.
By comparison, Hynix's corp bonds maturing in June 2017 are trading at around a 28 percent yield.
Tata Steel's 2012 convertible is trading 1,065 basis points above Standard Chartered's five year CDS. The two could normally be expected to trade in line because StanChart is backing Tata's bond.
Convertible arbitrage hedge funds have taken a beating this year -- losing roughly half of their investors' money, according to Hedge Fund Research's HFRX index.
Bond valuations came down drastically when hedge funds were forced to sell down, meaning convertibles -- designed to resist volatility -- fell in line with equities.
"The turmoil has been a combination of hedge fund redemptions and the unravelling of proprietary trading desks in investment banks. My understanding is that they've just shut them down," said Gary Vaughan-Smith, a fund of hedge fund manager at SilverStreet Capital.
Hedge funds typically buy a convertible bond, which allows investors to exchange it for the company's common stock, and short the underlying stock to hedge the equity exposure.
They then buy credit default swaps to hedge the credit risk, and their exposure to interest rates and foreign currencies through treasury futures or swaps.
Relative value arbitrage strategies, which include convertible arbitrage, have seen net outflows of nearly $15 billion in the second and third quarters, HFR said.
Higher borrowing costs have hit a strategy that normally uses leverage to boost returns, while funds scrambled to unwind their positions amid the collapse of Lehman Brothers, driving a free fall in the market.
But the turmoil has created opportunities the brave are willing to take. Barclays Capital Angus Allison expects the near-term market for convertible bonds to remain weak and volatile, but he said there could be a surprisingly sharp rebound for the strategy in the early part of next year.
Nevertheless nvestors have to be prepared for possible further pain.
"You buy the bond, buy the CDS from a bank, and the only risk you take is the CDS risk on the credit and what I'd call the Washington Mutual risk -- that the government decides to do something crazy," said GLG's Roman.
Recent months have shown that such highly unexpected events -- all but ruled out by risk models the financial community has come to rely on heavily -- do happen, especially after the collapse of Lehman Brothers.
Inevitably, such risk attracts investors.
SilverStreet's Vaughan-Smith sold out of convertible arbitrage funds in 2004 but has recently bought into a multi-strategy fund with convertible arbitrage exposure and says he may increase this further and says he expects these strategies to do well "once liquidity returns to the market".
"It's got to be the most out-of-favour strategy," he said.
"I may look to build this up in the next few months. Valuations there look phenomenal ... There is a much bigger mispricing than there was." (Editing by Douwe Miedema and Andrew Callus)