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Hedging back in vogue among lucrative convertibles

Date: Tuesday, July 21, 2009
Author: Laurence Fletcher and Daisy Ku, Reuters

Hedge funds stand to make gains from convertible bonds arbitrage again after last year's huge losses decimated the sector, though improving markets have made the job more complicated.

Managers have been using a simple "buy and hold" strategy to ride a big bounce in depressed bond prices so far this year, enjoying gains of nearly 30 percent.

However, bond prices have now recovered much of their losses -- 17 percent in the European, Middle East and Africa (EMEA) region, and 27 percent in Asia in the first half of the year, according to Barclays Capital.

"Six months ago the story was the completely ridiculous under-valuation of the market -- it made sense as a buy and hold strategy," said Paul Compton, head of product management at software group Sungard's alternatives business.

Share prices have risen to levels where they are "in the money," or above the conversion price, meaning convertible bond prices are more sensitive to share prices. Funds are reverting to a variety of tactics to hedge their positions.

"Now the stock market has kicked on a bit, we've gone toward normalcy and the options are a bit more interesting... A reasonable fraction is now equity-sensitive and funds are going back to... hedging," said Compton.

In what is called delta hedging, hedge funds are short-selling an issuer's stock to strip out equity risk and buying credit default swaps (CDS) to strip out default risk on the bond. They aim to make money from volatility and any mispricing of the bond.

"As the rally has already been quite good, we may start to see a shift by a greater number of funds toward arbitrage plays," said Societe General's Jose Antonio Gagliardi.


Despite last year's big losses, convertible arbitrage could become 2009's top strategy, as fewer funds fight over returns.

So far this year the strategy has made money every month and is the strongest performing strategy, as many companies continue to view convertibles as a cheap financing option, according to Hedge Fund Research.

"This year has been and will be highly supportive to their core business," he said, adding that funds will now have "an opportunity to extract returns through arbitrage," said Louis Gargour, founder of hedge fund firm LNG Capital.

However, bankers warn that the arbitrage strategy only works for liquid stocks.

After a strong first half with the convertible market dominated by big issuers such as ArcelorMittal (ISPA.AS), Vedanta Resources (VED.L), Eurazeo (EURA.PA), smaller companies are more likely to come to the market after the summer break, bankers said, helped by a pick-up in demand.

This means the ability for funds to hedge will be restricted because shorting these stocks is harder and they often lack CDS.

Like many leveraged arbitrage strategies, convertible arbitrage has suffered from plenty of competition in recent years. Returns in 2004 and 2005 were practically flat, even when the hedge fund industry was enjoying solid gains. It was a particularly tough place to be last year, with the average fund losing more than a third as bond prices sank, hit by forced selling as investors asked for their money back.

The tough trading conditions led many funds to shut -- for instance Preston Capital Management, a joint venture between GSA Capital and Andy Preston, former chief investment officer at KBC Alternative Investment Management.

But those survived become stronger, buying up new issues and allowing companies such as Anglo American (AAL.L) to raise as much as $1.7 billion in a jumbo issue arranged by Morgan Stanley (MS.N) and Goldman Sachs (GS.N) in April.

Globally, 1,527 companies raised a total amount of $274.2 billion this year so far, compared to $333.7 billion in the same period a year ago, according to Thomson Reuters data.