Mon, 03/12/2007 - 06:00
US convertible bond portfolios were in the midst of a strong recovery when the collapse of the sub-prime mortgage sector brought global credit markets crashing to a halt, according to U.S. Convertible Bond Investors Study issued by research firm Greenwich Associates.
The report says that, after two consecutive years of decline, the value of US institutions' convertible portfolios increased sharply to USD310bn during the 12-month period up to June this year.
'Prior to the outbreak of the 2007 credit turmoil, the convertible market had been on a roll since the market trough of 2005,' says Greenwich Associates consultant John Feng. 'Investor holdings were up sharply, and new issue volume was very strong.'
The strength of the market was due to a large extent to the return of hedge funds, many of which had shifted their focus away from convertible arbitrage after the meltdown two years ago.
'Hedge funds represent nearly three quarters of the universe of large convertible bond investors as of mid-year 2007,' says Greenwich consultant John Colon. Meanwhile the number of long-only funds in the market also increased, as did the average convertible long market value held by the average long-only investor.
As hedge fund managers return to convertible bonds, however, they are taking a different approach than that employed in the earlier era, the report says. Rather than dedicating entire funds to convertible arbitrage, they are integrating the strategy into multistrategy funds and approaches.
In 2005, the typical hedge fund convertible bond investor had just over half of its assets invested in convertibles; last year that share sank to 46 per cent, and by the early summer of this year, convertible hedge funds on average were devoting only 41 per cent of total assets to convertibles.
Despite this reallocation of assets, the growing number of hedge funds returning to convertible arbitrage and strong overall hedge fund inflows helped fuel the rebound in the convertible market, as did the increasing amounts of leverage deployed by hedge funds.
According to Greenwich, which defines leverage in this case as long market value plus short value, divided by capital, average leverage levels among hedge fund convertible investors increased to 3.4 times this year from three times in 2006 and just 2.4 times in 2005.
'In the run-up to this summer's market downturn, below-investment grade convertibles made up 53 per cent of the average hedge fund's convertible portfolio, compared with 40 per cent in the portfolios of long-only investors,' Feng says. 'As with most other fixed-income products, convertibles faced liquidity challenges over the summer, but it remains to be seen how investors will come out for the year.'
For the study, Greenwich Associates interviewed 154 institutional investors, a sample consisting of 76 per cent hedge funds and 24 per cent long-only investors. The total long-market value of these institutions' convertible holdings showed an increase from USD218bn in 2006 to USD310bn this year, when nearly 90 per cent of assets consisted of convertible issues from the US, with about 6 per cent from Europe and 5 per cent from Asia and Japan.
Average long-market value per institution was also up, to USD1.5bn for the average hedge fund and USD1.8bn for the typical long-only fund, from USD1.3bn for the previous two years running. The overall long-market value average was nearly four times the short-market value average of USD450 million for hedge funds.
About two-thirds of the hedge funds taking part in the survey now say they invest in convertibles as part of a multistrategy portfolio. Long-only investors were devoting 23 per cent of their capital to convertible investments at the time of the research, down from 31 per cent in each of the previous two years, bringing the proportion of total capital dedicated to convertibles among all US investors in the market 43 per cent in 2006 to 37 per cent.
'The research results point to a fundamental change in the convertible bond investor base,' says Greenwich consultant Jay Bennett. 'Only 20 per cent of convertible investors have 80 per cent or more of their assets in converts. The days in which single-strategy convertible arbs dominated this market appear to be behind us.'
Greenwich Associates is an international research-based consulting firm in institutional financial services, specialising in providing benchmark information on best practices and market intelligence on overall trends. Based in Greenwich, Connecticut, with offices in London, Toronto and Tokyo, the firm offers more than 100 research-based consulting programmes to more than 250 global financial services clients.
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