Credit swoon slows convertibles rebound, investment strategies in flux, Greenwich Associates report says

By Evan Weinberger

New York, Nov. 29 - The credit crunch that whipped through financial markets in the summer put a block on the recovery of the convertibles market, a new report released Thursday by Greenwich Associates said. The total value of the convertibles market rebounded to $310 billion in the year-long period ending in May-June of 2007, the period of the Greenwich Associates report. The market hit a correction in 2005.

"Prior to the outbreak of the 2007 credit turmoil, the convertible market had been on a roll since the market trough of 2005, Greenwich Associates consultant John Feng said in the report. "Investor holdings were up sharply, and new issue volume was very strong."

Much of the recovery in convertibles can be attributed to the return of hedge funds to the sector, the report said.

But those funds have shifted from a risk arbitrage strategy, the report noted, and moved to multi-strategy funds that included convertibles.

Prior to the 2005 trough, hedge funds had just half their assets wrapped up in convertibles. That fell to 46% in 2006 and by early summer was down to 41%. Around two-thirds of hedge funds surveyed by Greenwich Associates said they invested in convertibles as part of a multi-strategy portfolio.

Outright funds also increased during the period of the study, as did the average convertible long market value held by the average outright investor. Outright investors polled for the report devoted 23% of their capital to convertibles, a dip from 31% in 2005 and 2006. Total capital invested in convertibles in 2007 was down to 37% after standing at 43% in 2006.

"The research results point to a fundamental change in the convertible bond investor base," Greenwich Associates consultant Jay Bennett said. "Only 20% of convertible investors have 80% or more of their assets in converts. The days in which single strategy convertible arbs dominated this market appear to be behind us."

The increasing amount of leverage employed by hedge funds also aided the dollar inflow in the convertibles market. Greenwich Associates defines leverage as long market value plus short value divided by capital. Using that formula, the report said that the average leverage level among hedge fund convertible investors increased to 3.4x in 2007 from 3.0x in 2006 and 2.4x in 2005.

Below-investment grade convertibles made up a far larger portion of hedge fund holdings than they did for outright investors. As with much of the market, it remains to be seen how the two strategies will fare for the year. "In the run-up to this summer's market downturn, below-investment grade convertibles made up 53% of the average hedge fund's portfolio, as compared to the 40% they made up in the portfolios of outright investors," Feng said. "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."

Greenwich Associates interviewed 154 dedicated convertible fund managers and traders in the United States and Europe in vesting in U.S. convertibles in May and June 2007 for their report.

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