If smart investors buy when everyone else is selling, then the partners at AQR Capital Management have looked pretty shrewd lately. At the beginning of this year, they put $30 million of their own money into the firm’s convertible arbitrage strategy, which earned a 25.2 percent return through May.
“We are pounding the table that this is a great opportunity,” says David Kabiller, a founding partner of the Greenwich, Connecticut–based firm. “We have huge conviction for anyone who has no exposure to convertible arbitrage.”
Don’t mistake that for a bet-the-farm endorsement. Kabiller recommends that hedge fund investors should have just “a little” convertible arbitrage. That’s as far as he’s willing to go, although by AQR’s reckoning convertible bonds are cheaper than ever — except for when the market collapsed last fall before rebounding early this year. The once–$40 billion AQR took a beating in 2008, but it still has about $14 billion under management in long-only strategies and an additional $6 billion in hedge funds, part of which (Kabiller won’t say exactly how much) is dedicated to convertible arbitrage.
The rally in convertible arbitrage isn’t confined to AQR — it’s the best-performing hedge fund strategy so far this year: The HFRI convertible arbitrage index was up 24.8 percent through May. This recent show of strength comes after a disastrous 2008, when the combination of high leverage, crowded trades and concentrated ownership left convertible arbitrage funds uniquely vulnerable to the frozen credit landscape following the collapse of Lehman Brothers Holdings in September. AQR’s convertible arbitrage strategies lost 30 percent in 2008. But that’s better than the HFRI convertible arbitrage index, which was down 34.4 percent, and major competitors like Chicago-based Citadel Investment Group and New York–based Highbridge Capital Management, each of which lost more than 40 percent in the strategy.
Arbitrageurs have long been attracted to convertible securities, which are typically issued as a last resort by emerging companies or by established ones that have fallen on hard times. Convertible securities pay a fixed interest rate, like a straight bond, but also give investors the right to convert bonds into equity at a predetermined price — they are, in effect, a call option on common stock. Arbs use computer models to value the separate components of a convertible security, and if they can buy them in the market for a cost that is less than the sum of the parts, they can profit from that discount.
The classic trade is a “delta neutral” hedge: going long on a convertible bond and short on just enough of the common stock into which it converts that price movements between the two positions offset each other. Kabiller says that that’s the way AQR plays the trade, although he acknowledges that some managers make purely directional bets. The hedge itself is more complicated than it appears because the price of a convertible bond depends on interest rates, credit spreads and equity volatility as well as the price of the underlying common stock. In theory a convertible arbitrageur can hedge the credit risk separately through a credit default swap on the issuer, but in reality many companies that issue convertible bonds are too small to support a single-name swap.
“Arbs can account for the credit risk in setting the delta,” notes Mark Mitchell, a co-founder of and principal at CNH Partners, an affiliate of AQR. “They sell more shares short.” Once a position is established, prices bounce around — and the optimum delta-neutral hedge shifts. If the stock price ticks up, convertible arbs sell more shares short to increase the hedge ratio; when the price falls, they buy back part of their short. The profits generated by changes in the delta hedge juice the returns, and the more volatile the stock price is, the greater the opportunities for managers to make money using options.
So why, then, did convertible arbs get killed in 2008, when volatility soared to unprecedented heights?
Though plenty of hedge fund strategies unraveled during last year’s market meltdown, convertible arbitrage took the worst beating. The trouble began early. Convertible arbs were struggling well before the failure of Lehman. Returns were weak in the first half of 2008 (down 6.2 percent from year-end 2007). Hedge funds accounted for most of the action in convertible bonds — estimates range from 55 percent to 70 percent of ownership and as much as 80 percent of trading volume — and too many big players held the same names. In addition, the market had absorbed a great deal of new paper, particularly convertible preferred stock issued by troubled financial institutions trying to shore up their weakened balance sheets.
Then on September 15, Lehman — which had served as prime broker to many convertible arb funds — filed for bankruptcy. Within hours the phones at Basso Capital Management, a multistrategy hedge fund firm based in Stamford, Connecticut, were ringing off the hook. Counterparties that had taken convertible securities as collateral against loans to Lehman were looking to sell at any price. “People in Asia couldn’t even pronounce the names of the bonds they were trying to sell — it was panic selling,” recalls Howard Fischer, founder and CEO of Basso. (He declines to reveal the amount of assets under management, but in its most recent public filings, Basso reported holding $249 million in securities.)
As counterparties that had lent securities to Lehman were scrambling to unwind those positions, new stock-loan commitments slowed drastically, jacking up the cost of running short positions. Under pressure to reduce leverage, prime brokers cut back or even eliminated credit lines against convertibles with little or no notice. An industry operating at that time on 2.5 to 3 times leverage (down from an average of about 4.5 times in early 2008) had to shrink in a hurry — and the only natural buyers were all in the same boat.
William Crerend, CEO of EACM Advisors, a $3 billion fund-of-hedge-funds firm based in Norwalk, Connecticut, says the biggest factor in subsequent performance by convertible arbitrage managers was the amount of leverage they had when Lehman failed. By the fall of 2008, EACM had been skeptical of dedicated convertible arb funds for some time, based in part on the concentrated hedge fund ownership. Its only exposure was through multistrategy funds and amounted to less than 10 percent of its portfolio.
Even the dealers couldn’t step up to save the convertible bond market — the major banks and securities houses were shutting down their proprietary trading desks to free up capital. And then regulators threw gasoline on the fire by banning short-selling. In the U.S. the prohibition applied only to financial stocks, but other countries imposed broader restrictions. “The convertibles became dissociated from the underlying equity,” explains Fischer. “Nobody knew when the restrictions were going to end, so the risk premium in convertibles expanded even more.”
Basso and other firms that had bought CDSs to hedge their risk took another hit when credit spreads ballooned. The price of cash bonds — straight debt securities as well as convertibles — tumbled far more than CDS prices rose. Whenever managers use an instrument that isn’t fungible with the position they are trying to hedge, they run the risk that the two prices will diverge, and in this instance the size of the gap that opened up was unprecedented. Fischer recalls how trades that had been set up to generate positive cash flow of 50 to 100 basis points blew out to anywhere from 1,000 to 2,000 basis points. As convertible arbs and other credit investors rushed to undo their trading books, bond prices sank — but the price of swaps intended to hedge the positions didn’t rise anywhere near enough to offset the losses because investors had to dump those too.
On top of all this, panicked investors began to ask for their money back, triggering yet another round of selling to meet redemption requests. The low point came in November. CNH’s Mitchell says convertible bonds got so cheap that some were trading at higher yields than straight debt from the same issuer. Investors weren’t just getting a free option on the company’s equity; they were being paid to take it. Other convertibles that were in the money traded at parity with the common stock into which they could be converted, giving bond investors identical exposure but with a higher yield and a superior position in the capital structure.
Even people who knew nothing about convertible arbitrage couldn’t resist. Encouraged by the major convertibles dealers, fixed-income and equity managers began to buy. Companies waded in as well, drawing down revolving credit lines to buy their own convertible bonds — as much as 10 percent of the outstanding issuance in the U.S. after Labor Day 2008, by Mitchell’s estimate: “Cash-strapped companies were buying back convertible bonds because they offered a better return than any other project — that’s how cheap the asset class became.”
The largest surviving player dedicated solely to convertible arbitrage is probably Waterstone Capital Management, an $800 million Minneapolis-based hedge fund firm that bucked the strategy’s losing trend in 2008 by delivering a 12 percent return. Shawn Bergerson, the firm’s CEO, attributes the performance to high-quality credit research and some well-chosen event-driven trades.
“We did a good job picking winners and shorting losers in the credit space — we largely avoided the companies that went out of business and had some significant winners that were taken over,” Bergerson says. Waterstone bypassed convertible bonds issued by carmakers, airlines and banks.
Bergerson says the rebound took hold in late November thanks to aggressive efforts to drum up interest in convertibles among buyers beyond hedge funds. “The dealers demonstrated to potential investors that convertibles represented the best value in the capital structure,” he explains. By January new buyers dominated trading in the convertibles market; Bergerson estimates that 70 percent of outstanding bonds are now owned by investors other than hedge funds. This massive redistribution of bonds in the past few months has corrected an unsustainable imbalance and created a much healthier market environment for convertible arbitrageurs.
“Those of us who are left will have more opportunities,” says Bergerson. “We all look at convertibles from a relative-value or equity volatility perspective, but these other investors value them in different ways.”
In keeping with their hybrid nature, convertible bonds have benefited from the strong rally in equity markets that began in March and from the simultaneous narrowing of credit spreads across the board. “The combination pushes convertible bond prices higher irrespective of any valuation improvement,” notes Claire Smith, a partner and research analyst at Albourne Partners, an investment consulting firm based in London that focuses on alternatives.
Discounts to fair value have narrowed — and probably have further to fall — but Smith questions whether they will shrink back to where they were before the shakeout. Convertible arbs, she explains, can’t muster the same buying power from a smaller capital base using less leverage. And even if the banks were willing to lend more money, Smith reckons that managers wouldn’t take it.
“They have been scared,” she says. “The managers who are still in business are thanking their lucky stars. Nobody wants to rely on bank financing when the prospects for banks are still pretty opaque.”
EACM’s Crerend estimates that convertible arbitrage funds today are using 1.5 to 3 times leverage, with a bias toward the low end of that range. Lower leverage diminishes the risk of another catastrophic meltdown; an industry leveraged at 1.5 times assets today could be forced into using no leverage at all, but that would be less wrenching than when its leverage went from 3 times assets to zero last fall.
Despite this spring’s rally in equities, stock prices are languishing far below the conversion price for many seasoned convertible issues, which means that the fixed-income component dominates their valuations. That puts a premium on credit analysis, a skill at which not every manager excels. In today’s market, Smith points out, some busted convertibles (bonds that trade well below the conversion price, almost as if they were straight bonds) are trading at 30 to 40 cents on the dollar, which offers a spectacular return if they pay out at par and a disastrous loss if they don’t. “Managers who have those in their portfolios had better be very confident of their credit work,” she says.
AQR’s Kabiller agrees. He says he’s mystified by some investors’ preoccupation with long-only credit plays, however. People who were too scared to invest money in convertible arbitrage at the lows now see AQR’s fund up 25 percent and worry that they’ve missed the move — even if valuations are still cheap. “What else can you buy that has close to zero correlation with equity markets, low correlation to debt markets on average and this kind of expected return?” Kabiller says. “Yet people don’t seem to be coming back to it in droves.”
