Convertible arb's 7.7% Q1 return leads hedge fund strategies, Credit Suisse/Tremont says

By Rebecca Melvin

New York, May 14 - Convertible arbitrage went from being one of the worst-performing strategies in the Credit Suisse/Tremont Hedge Fund Index in 2008, to one of the best-performing strategies in the first quarter of this year, returning 7.7%, according to a report published by the Index.

In fact, convert arb led the index with its 7.7% first quarter performance, while equities' performance for the same period came in at negative 12.5% (as represented by the MSCI World Index) and hedge funds returned 0.85%.

The fundamental and technical reasons for this revaluation may correct as credit markets begin to stabilize and if deleveraging continues to abate, according to a new report from Credit Suisse/Tremont called Convertible Arbitrage: Shifting Gears.

In January, convertible bond yields were atypically more attractive than straight bond yields with similar maturity and seniority in the capital structure.

Although yields have dropped since their highs at the end of 2008, the resurgence of new issuances as well as continued cheapening of the asset class points to a possible continuing rebound of convertible arbitrage in 2009 if conditions in the credit markets continue to improve, the report says.

Volatility trading was curtailed during the large declines of late 2008 and early 2009, but it may come back later in the year if equity markets stabilize, albeit with a reduction in the use of leverage.

A few roadblocks have emerged for the volatility arbitrage aspect of convertible arbitrage, which may take some time to resolve, depending on macroeconomic shifts and market movements. In particular, the sharp fall in equity prices in 2008 and early 2009 resulted in a drop of the underlying share prices for many convertibles below the strike price.

With regards to the convertible option, this resulted in many convertibles being deep out of the money, and therefore out of the range of arbitrage opportunities. Arbitrage plays typically used leverage of around 4x in order generate target returns in the past, and most hedge funds have reduced their use of leverage to anywhere from 0x to 1.5x as a result of the credit crisis.

Finally, the rising cost of CDS and the higher cost of borrowing have made it more difficult to secure proper credit hedging and isolate the volatility exposure for lower grade names. As a result, many convertible arbitrage managers have expressed the view that they are more likely to approach opportunities in the convertible space as a way to play the credit long side with little or no leverage, applying their credit analysis expertise and knowledge of the convertible bond markets.

Although volatility trading has been curtailed, it has not stopped altogether, and there are scenarios in which volatility trading could see a resurgence with an equity market recovery, albeit with lower leverage and lower returns, the report says.

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