Investors adapt to market downturn in US convertibles

The long-market value of institutional holdings of US convertibles plunged almost 20 per cent over the past year to approximately USD 240 billion.


The drop is a result of challenging market conditions prompting some hedge funds and other convertibles investors to diversify their strategies or abandon the market altogether.


Greenwich Associates' 2005 Convertibles study analyzes the downturn in the US convertibles market and examines the simultaneous increase in the value of convertible portfolios among European institutions. The report also presents Greenwich's most recent research findings on average spreads on convertible bond trades, leverage ratios among hedge funds, and the use of individual products and strategies within the portfolios of convertible investors.


US Convertibles Market


Demand for US convertibles slackened over the past 12 months due to declines in capital in-flows and the decrease in leverage ratios on the part of hedge fund investors. Meanwhile, disturbances in the credit bond market -- most notably the downgrading of US automakers -- drove up spreads on corporate bonds and convertibles alike in the first half of 2005.


Their negative impact on convertible portfolios was compounded by stock price movements on take-over rumours, while low volatility levels continued to depress option value.


"Losses incurred by some convertible strategies were also amplified by employed leverage, leading a number of funds to sharply reduce their convertible holdings or even abandon the strategy altogether," says Greenwich Associates consultant Jay Bennett.


Such strategic decisions on the part of hedge funds are having a profound effect on the market for US converts. "Many hedge funds that invest in convertibles are diversifying their investment strategies," says Greenwich Associates consultant John Feng. "This shift is in part a response to the troubles in the convertibles market, but it can also be seen as part of a broader move toward diversification that is taking place among US hedge funds. Greenwich Associates research reveals that hedge funds of all types are moving away from their conventional single-strategy approach by adding additional investment strategies within their funds."  As a result of such diversification, convertibles represent only 45 per cent of the average investor's total capital under management.


Outright investors and hedge funds traded a combined USD 290 billion in US convertible bonds over the past 12 months, in addition to USD 60 billion in trades of convertible preferreds and mandatories. Hedge funds were clearly more active traders, with an average 12-month trading volume of almost USD 1.9 billion per fund in convertible bonds -- roughly double the average annual trading volume of outright investors.


Hedge funds remain active users of convertible-related credit derivatives: about 70 per cent of these investors applied credit default swaps on nearly half of their investment-grade positions and on almost a quarter of below-investment grade assets. In addition, just over 40 per cent of hedge funds continue to use asset swaps. While few outright funds are active in credit derivatives, they have shown clear interest in synthetic convertibles, with half of them buying the product. However, at just 8 per cent, synthetics remain a minor part of the typical outright investor's portfolio.


European Convertibles Market


In contrast to considerable declines in the US, the long-market value of total convertible holdings by European institutions rose 10 per cent over the past year to approximately EUR 160 billion, thanks in large part to the growing interest in convertible products with Asia/Pacific underlyings. Greenwich Associates' research reveals the average European fund dramatically raised its Asia/Pac allocation from 9 per cent in 2004 to 23per cent in 2005.


"In contrast, Asia/Pac convertible holdings remain a modest 9 per cent among US-based institutions," says Greenwich Associates consultant John Webster, "This shows that most of the Asian and Japanese convertible investing is done either in the region or out of Europe."


The hedge funds' influence on the European convertibles market has declined in recent years, as they now represent less than 60 per cent of the total number of active convertible funds, compared with 70 per cent two years ago. Despite decreases in hedge fund leverage ratios from 2004 to 2005, the European convertible portfolio of the typical hedge fund, which averages approximately EUR 1.4 billion in long-market value, remains considerably larger than the average holdings of outright investors -- just about EUR 850 million.


Trading volumes for European convertibles over the past year were smaller than those for US convertibles at a projected EUR 150 billion. The typical hedge fund investor in European convertibles traded about EUR 1.1 billion of the product from 2004 to 2005, while outright investors' average trading volume totalled about EUR 900 million.


The pursuit of diversified investment strategies is also apparent in Europe, where the average fund invests just one-third of its total capital in convertibles: higher at 40 per cent among hedge funds, compared with just 25 per cent for outright investors. European hedge funds are even more active in credit derivatives than their US counterpart, with 85 per cent of these funds buying credit default swaps and two-thirds using asset swaps. Conversely, three quarters of European outright funds have invested in synthetic convertibles, which have yet to be widely adopted by hedge funds.


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