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Spotlight on Bonds: At the Interstices of Debt and Equity
Source: HedgeWorld - Inside Edge
Date: August 4, 2004
Author: Chidem Kurdas
This is the fourth in a series of articles on various bond strategies
NEW YORK (HedgeWorld.com) - May and June were red-ink months for convertible arbitrage managers as a group, giving credence to some investors’ opinion that this strategy is now past its cyclical peak.
Convertible issuance grew significantly over the past decade, and hedge funds have become increasingly active in this market. Convertible arbitrage was one of the top-performing hedge fund sectors after the stock bubble deflated in 2000 and now is a fixture in many fund of funds portfolios.
The strategy may be evolving in response to shifts in the economic environment and market opportunities. For instance, hedging against interest rate changes has become more important as rates move upward and uncertainty remains as to how high they will go.
“More managers are taking an interest in the hedging function we provide,” says Paul Compton of SunGard’s Monis unit in London, a provider of tools for pricing and analyzing convertible bonds, including ways to calculate risks and decide what hedges are required.
Common Ground
Monis has up-to-date data on approximately 2,000 convertible securities worldwide, almost all of them traded over the counter. Its system will calculate risk factors for interest rate exposure and generate reports that quantify this risk at each point on the curve.
The more than 150 hedge funds that use the service are mostly in convertible bond strategies, but lately managers with a focus on credit arbitrage and capital structure arbitrage have become a noticeable presence among users.
This broadening appeal of convertible bond analysis is evidence of another change. Some convertible arbitrage managers have diversified their portfolios into capital structure trades. Other firms have set up separate capital structure arbitrage funds and raised money for these.
What credit, capital structure and convertible arbitrage have in common is “looking at debt and equity and derivatives for one company at a time, trying to extract value from those relationships,” said Mr. Compton. So these strategies share some risk exposures and the same data are relevant.
In all three, understanding the relationship between debt and equity is key to identifying arbitrage openings, whether or not a convertible bond is traded. Is one instrument undervalued relative to the other? Arbitrage profits come from such discrepancies.
A Crowd
Jeff Bohn of Moody’s KMV, a San Francisco-based supplier of estimated default frequency analytics and data, described the same phenomenon. In capital structure arbitrage, a manager can calculate the hedge between equities and bonds while going long the undervalued securities and short the overvalued securities of the same company.
He said there is a lot of basis risk in that trade. “Not a trade for those with a weak stomach,” Mr. Bohn said. “You have to be comfortable with the analysis of the different pieces. But that’s where the opportunity lies.”
The analysis may include estimated default frequencies, price-at-risk in each market, the recovery expectation, and liquidity concerns. Some funds have done very well in this niche, but now more people are doing similar trades and there is concern that it might get overcrowded.
As for the convertible market, that may be congested already. On the other hand, hybrids such as convertibles offer a variety of arbitrage possibilities and a wider range of companies have been issuing them in recent years. Whether this growth in diversity and the opportunities it opens up can keep up with the inflow of money is the question.
Previous articles in this series: To Hedge or Not To Hedge , Choose a Risk to Find a Source of Alpha and Unpacking the Yield Reveals Complex Pattern
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