By Barclay T. Leib

The Art of the Heavy Hedge

How convertible bond arbitrageurs escaped the telecom crash by overhedging their porfolios.

In the spring of 1996, Times Mirror Corp. came to Morgan Stanley with a hedging problem: The firm had a huge gain on its investment in Netscape Communications, and it wanted to sell its stock, but didn't want to roil the market or pay all the capital gains taxes on its holdings.

Morgan Stanley's brilliant solution was to underwrite a Times Mirror convertible bond that had a mandatory conversion feature into Netscape stock. That meant investors would be given a fixed-income instrument bearing a coupon, but the security would eventually morph into Netscape stock after several years. Times Mirror, meanwhile, could defer paying its tax bill for several years. Shouldn't everyone have been happy?

Despite the nifty concept of earning a coupon while participating in an Internet high-flier, convertible investors turned a cold shoulder—deeming the issue just too speculative for the times. The deal was sold, but just barely, and at terms that made it the "cheapest mandatory convertible ever issued up to that date—and ‘jammed' on any Morgan Stanley clients that would take it,” according to one dealer.

That well-publicized flop put the kibosh on the issuance of Internet convertible paper until 1998, when AOL issued a less scary-looking convertible with more traditional non-mandatory conversion rights and a definable bond floor value. Since AOL had a better credit rating than Netscape, as well, the deal was successfully placed. The stock of AOL subsequently vaulted higher, and any convertible bond manager who didn't buy the AOL issue suddenly looked like a dummy. "If you didn't own the AOL issue as a convert manager, you underperformed in 1998—it was just that simple,” says Kendrick Wakeman, managing director of the convertible bond research group at First Union Securities. "AOL simply trounced everything, and traded up to well above 10 times par. I believe it accounted for almost 98 percent of the return to the Merrill Lynch Convertible Bond Index that year.”

In January 1999, Wakeman visited some 20 outright convert investors and found a unique theme emanating from them. "Each one of these investors was wondering what to do about the Internet,” says Wakeman. "They didn't like Internet stocks, they didn't understand Internet stocks, but they knew these underlying companies were now part of the convertible indices, and they couldn't afford another AOL-type situation of being left at the gate. They had to participate in that space, and the investment bankers responded with a flood of new issuance.”

The issues that came forth stretched from Beyond.com, to Exodus, to DoubleClick, C-NET, Mindspring and the now-famous 10-year Amazon.com convertible issue. Some performed well for a little while, but most finally crashed and burned in this year's April-May Internet market collapse. Many Internet convertible bonds fell faster in value than their theoretical hedge ratios implied. The Amazon issue now trades at only 60 percent of its face value, with a 12.5 percent yield-to-call—not quite a distressed security but slowly moving in that direction. Outright buyers of convertibles may now be benchmarked better vs. their indices, but many of their holdings are well under water.

In this sort of environment, you might expect to see some sad faces among convertible bond arbitrageurs as well. You'd be wrong. Convertible arb funds stacked up an average 18.12 percent return on the CSFB/Tremont Hedge Fund Index through July. And those returns are coming after a stellar 1999, when many convertible bond managers achieved annual returns above 40 percent. For arbitrageurs at least, it is the best of times in the convertible bond arena, not the worst.

Why have the convertible arbs done well in the face of such a difficult underlying market? The answer is two-fold, but relatively simple.

First, "it's simply the ongoing high level of equity volatility we have seen,” explains Jeff Seidel, director of global convertible research at Credit Suisse First Boston in New York. "Credit spreads have remained wide, but unlike 1994, when we faced seven rate hikes, the bond market behavior has been relatively benign. And the underlying equity volatility has just been massive—sometimes so fast in jump moves that there is no opportunity to delta hedge—which is good for a convert manager, especially on the downside.”

Second, when arbitrageurs bought much of the Internet convertible bond issuance and other low-grade telecom paper that flooded into the market in 1999 and early 2000, they deliberately overhedged their convertible holdings with sales of stock.

They did so mindful that if a weak credit's stock falls, the underlying credit quality of the bonds that they were purchasing was likely to deteriorate as well. In actuality, this is exactly what transpired in the Internet sector, and unlike in 1998, this time the hedge fund managers saw it coming and benefited.

"If any arbitrageur bought the Amazon issue and shorted anything less than 95 percent of the stock against it, that manager would have had a tough time making any money on that transaction” says Vadim Iosilevich, director of New York-based hedge fund Alexandra Investment Management Ltd. "Even with a heavy hedge, that bond fell so fast, it was difficult to capture much gamma.”

A Convertible Market Primer

Convertible bonds are bonds with embedded options in them. The buyer receives a fixed-income instrument, typically with a coupon between 4 percent and 6 percent, but the right to convert into the underlying shares of the issuing company at a set conversion price. In most deals, this conversion level is initially set 20 percent to 30 percent above the current stock price, and the difference is referred to as the conversion premium. The combined security has the characteristics of a bond plus a longer-dated warrant (option) on the underlying equity. If the stock performs well, the convert clause will begin to dominate the issue's market value, and the bond will begin to behave more and more like the underlying equity. If the stock does not appreciate, the convertible will migrate instead toward its pure bond value. Because of the optionality embedded in a convertible, young companies typically are able to raise cheaper financing by using this sort of a structure rather than going for a straight issuance of debt or stock. Many convertible issues regularly get socked away by mutual funds, pension plans and insurance companies on an outright basis. These holders often must satisfy certain criteria (such as a coupon or dividend being payable) on their holdings. Insurance companies also face significantly lower National Association of Insurance Commissioners reserve requirements for investments that can be deemed a bond rather than outright equity. All of the holders of convertibles, however, are attracted by a convertible's equity kicker—the little bit of extra equity zing—that convertibles add to their portfolios. Convertible bond arbitrageurs, however, follow a very different course. While they, too, typically buy the convertible bond issuance, they then sell a delta amount of the underlying stock against the long convertible holding. By doing this, they end up earning not only the coupon on the convert, but also a rebate on the short sale of the stock. By adding a bit of leverage on top of this, the manager can often create a positive cash flow, otherwise referred to as a standstill rate of return. The short sale of stock also turns the embedded long call of the convertible into a long volatility position on the underlying equity. Because the convertible bond is indeed a bond, the arbitrageur must, of course, worry about the overall level of interest rates in the economy and the specific credit rating of each bond positioned. Higher market rates caused by either factor can ruin an otherwise well-analyzed convert trade. This is called, respectively, the "rho risk” and credit exposure of convertible bond arbitrage. When necessary, hedge fund manager can use interest rate futures, credit derivatives and over-the-counter swap transactions to hedge away these risks, usually at some added cost. Once a manager makes mental or actual hedging adjustments for credit risk and interest rate risk on the bond portion of his holding, the manager is usually able to back out an attractive implied-volatility level for the option portion of his investment. In the United States, for example, where the one-year historical volatility of Nextel has been running at 55 percent, one might expect to see three- to five-year convertibles on Nextel trading at an implied volatility of under 40 percent, priced to the first call date. If a manager is bold enough to discount the possibility of a merger or other corporate event that might hurt the life expectancy of his option or its gamma value, such a convertible would be an attractive security to position and trade against. The manager could sell short a sufficient amount of the underlying stock, and then readjust that hedge as Nextel gyrates up and down—buying back stock on plunges and selling more into rallies. If the actual volatility of Nextel stays above the 40 percent implied volatility that the manager has paid for his embedded option, the manager will make money. Convertible bonds can be structured to look more like equity (with a low coupon and low conversion premium), or more like a bond (with a high coupon and high conversion premium). Some bonds have call features that allow a company to force early redemption or conversion into stock—typically in three years, but sometimes sooner. Occasionally, convertibility also comes with a "screw clause” that allows a company to give notice that a bond is being called, but to avoid paying a final coupon that might be due just days after the final call window closes. Terms for the handling of takeover and merger situations also bear careful attention. A convertible may become callable in the event of a takeover, but continue to exist (with a better or worse credit rating, as the case may be) in the event of a merger. Trading convertible bonds is, in short, somewhat akin to playing a multidimensionial game of chess. A host of different parameters must be considered—both from a market perspective and in the wording of the accompanying legal documentation. — B.L.

New "Make-Whole” structures

The other trend in the convertible business that has been kind to the arbitrageurs is the advent of certain "make-whole” provisions never seen before. In bonds of this type, a company has the right to call a bond at any time (not simply after the three-year norm). In that case, an investor is guaranteed to get back one of two things. In "coupon make-whole” bonds, the investor receives a given number of unpaid coupons in one lump sum. In "premium make-whole” bonds, the investor gets back the excess premium paid above the parity equity value for the bond. Thus, in the latter instance, if an investor has paid par for a bond with an initial equity value of, say, 85, and the stock doubles and the company then calls the bonds, the investor would get back stock plus the extra 15 points of premium paid up-front.

"Investors didn't like Internet stocks, they didn't understand Internet stocks, but they had to participate and the investment bankers responded with a flood of new issuance.” — Kendrick Wakeman, First Union Securities

"Using this type of structure, corporate treasurers have the chance to immediately flush debt into equity if their stock performs well,” says Alexandra's Iosilevich. "The outright and arbitrage investors tend to be pretty happy, and while immediately dilutive on existing shareholders, this latter group can hardly complain since, by definition, the company has raised needed capital and the stock still went up.”

One issue that contained a coupon make-whole provision earlier this year was Human Genome Sciences. That 5 percent issue with a December 2006 expiry was issued in February 2000 at a 22 percent premium to its equity conversion value with a three-year coupon make-whole provision. The stock then exploded higher, and within six weeks the company called these bonds, agreeing to pay out three years of 5 percent coupons (or 15 bond points) in order to retire this debt into stock.

"Why NOT call these bonds in such an instance?” asks Iosilevich. "If the treasurer doesn't call the bonds early, he's going to have to pay all these coupons anyway, and he risks the stock going back down. It's better to just pay the coupon make-whole, and remove that debt from the balance sheet.” Even with a short equity hedge, Iosilevich says, "whoever bought those bonds did very well.”

Put-able discount varieties

Arbitrageurs have also taken advantage of yet another twist in convertible issuance, although this newest twist has yet to be as rewarding as other areas of the business. In the second and third quarter of this year, shortly after the Internet convert craze unraveled, a number of oil services companies issued a series of high-grade zero-coupon discount convertibles with three-year put provisions. The issues were typically exchangeable into underlying stock 30 percent to 40 percent higher than the prevailing equity market—a rather lofty conversion premium.

Some arbitrageurs groused at such terms, but the deals were popular because they were also "put-able” back to the issuing companies at par in several years' time. The bonds offered investors a low-risk way to gain some long exposure to a company—and they would at worst end up with a three-year discount note on an investment-grade name.

"One deal got printed and then a flurry more followed,” explains First Union's Wakeman. "The volatility of the oil sector is pretty high these days, and both that and the zero-coupon structure of these deals appealed a great deal to the issuers.” He thinks some buyers may have positioned these bonds outright as a low-risk way to gain a positive exposure to this sector. But because the credit derivatives market also became active at the same time, "A few large European hedge funds were likely involved, swapping out the credit exposure to synthetically create just a volatility bet,” he says.

"These deals were not exactly cheap,” adds Alexandra's Iosilevich. "To participate here, I think you really had to have wanted the volatility exposure. When I have seen such aggressive pricing of convertibles in the past, it has usually been an anecdotal sign that the market was overheated and ready for a correction.”

Trouble Ahead?

Hedge funds now call the shots in the convertible market. But what happens when they want to unload?

Almost anyone you ask will say that buying a convertible bond is a less risky investment than buying the underlying equity. Not only do you have the cushion of the convertible coupon, but, by definition, a convertible is farther up the food chain of a company's balance sheet than common equity.

Notwithstanding this fact, the U.S. convertible bond market has arguably become the riskiest convertible market in the world. In Japan and Europe, most convertibles are issued by investment-grade names. But in the United States, only 12 of the 29 Internet convertibles brought to market over the past 18 months carried any credit rating at all. Young technology and telecom issues, moreover, now represent more than 50 percent of the U.S. convertible bond universe.

As a result, the U.S. convertible market has largely supplanted the now-illiquid U.S. junk bond market of yesteryear. "The junk market net-returned just 1 percent last year, compared with the huge performance of the convert market,” says Graham Clark, a director in Merrill Lynch's equity-linked capital markets group. "It is pretty easy to see why converts have grown in popularity.”

"You can't place most telecom junk paper very attractively anymore, but you can still price most telecom convert paper,” adds Jeff Seidel, director of convertible bond research at Credit Suisse First Boston. "Because the volatility of the equities has been so high, people really want the embedded option, and while there is attention to credit spreads, it's generally less rigorous because that option is there. If you've got a good story, and a volatile share, the convert market still offers attractive financing terms.” In other words, high equity volatility and a closed junk market results in a busy convert market. Seidel expects that trend to continue, "whether individual issues trade well in-the-money where hedge funds can set up free put positions, or fall into the distressed category where high-yield investors will be searching for beaten-up credits that will survive.”

"I've just seen liquidity crisis after liquidity crisis develop, and I think the next one is going to be more severe than the other ones.” — James Burns, Aventine Investment Management

The question remains, however, whether the U.S. convertible market could seize up again in another 1998-like bout of illiquidity. According to some, the market is less exposed now than it was before Long-Term Capital Management's meltdown, but according to others, it's just a matter of time until the next financial accident.

Reduced holdings

The low credit quality of many of today's U.S. convertible bonds has understandably encouraged many banks to cease positioning these bonds on an outright basis. "1998 and the LTCM crisis not only taught many hedge funds how to construct better delta hedges, but it also taught many banks how dangerous this market can be,” says Vadim Iosilevich, a convertible arbitrage trader and director of Alexandra Investment Management Ltd. One Connecticut-based convertible arb manager adds, "If Merrill Lynch used to be running a $3 billion convertible book, now they are likely to have just a $300 million book, run in a much more risk-appropriate way.”

But if the banks are no longer positioning this paper on an outright basis, who are the ultimate holders? A quick look at a Bloomberg terminal will tell you that large aggressive mutual fund families such as Janus and AIM are often among the largest holders of Internet and telecom convertible paper. After all, back in 1998, how else could the Janus Balanced Fund actually beat the returns of the Standard & Poor's 500 while still having bonds constitute 60 percent of its portfolio? Convertibles, of course. While not exactly creating true balanced or conservative portfolios, Janus has shown that you can take a handful of hot convertible bond issues and make them almost be as good as owning stock—without actually having to admit to such exposure. In 1999, out of a universe of several thousand available issues, 10 specific high-tech names accounted for a quarter of the returns of the Merrill Lynch Convertible Index—all names near and dear to the Janus fund family.

On the other side of the equation, hedge funds, ironically, are now more important than ever as the primary liquidity providers to such outright convertible buyers. According to some estimates, convertible bond arbitrage trades currently represent more than half of the secondary-market trading in convertible securities at the institutional level, and the driving force here are multibillion dollar hedge funds such as Staro, Highbridge, HBK, Ramius and Citadel. This is a group of names few outside of the hedge fund industry would be likely to recognize, and yet their behavior might prove of some importance if the large mutual funds were ever forced, through redemptions or otherwise, to liquidate some of their massive convertible holdings.

"When Janus or any other large mutual fund group takes down relatively large chunks of converts, you want them to be long-term holders,” says CSFB's Seidel, "because if they want to blow out $50 million in converts, it's not like blowing out $50 million in stock. In a major liquidation, you'd likely see a ratcheting down in bids from the hedge funds. I've never seen a situation where there is no bid in the U.S. market, but it has happened in Asia.”

Synthetic and Reverse Converts

Unless a company is a fast-growing startup, the issuance of convertible debt is often viewed by market participants as potentially equity dilutive, and a general sign of corporate weakness. Because of this, many high-grade companies have stayed away from the convertible bond market in recent years, particularly in the United States. The cost differential between issuing straight bond debt and convertible debt has simply not been sufficient to attract blue-chip companies to this market on a consistent basis. There is, however, a natural demand for investment-grade convertible paper, and when little exists that's suitable for a pension fund or insurance company to buy, Wall Street regularly creates synthetic convertibles. In such an issue, a large investment bank will combine its own credit in a note that also contains a longer-dated option on another company. Credit Suisse First Boston, for example, has issued a number of deals bearing CSFB credit, a 2 percent coupon, and an exchangeability feature allowing the bonds to become registered shares of, respectively, Novartis, UBS or Zurich Insurance. Morgan Stanley and Merrill Lynch have also been quite active in this market. "I'd estimate that the synthetic market is still just 5 percent of total convert volume,” says Graham Clark, a director in Merrill Lynch's equity-linked capital markets group. "These products have been around since the early 1990s, but the growth of them recently has been particularly strong.” "Every now and then, an investor sees exceptional growth potential in a stock, but is precluded from investing in that stock due to that investor's investment restrictions,” says Kendrick Wakeman, managing director of the convertible bond research group at First Union Securities. "These investors typically need an income-producing instrument to gain access to the stock, and synthetics can be created to fit that bill.” About half the time these products emanate out of specific customer demand, according to Wakeman. Other times, an investment banker may spot an opportunity in a given equity and try to sell the concept of a synthetic to the outright players. Because a derivatives desk must become involved to sell the longer-dated option portion of the convertible, these deals do not tend to be particularly cheap. Instead, according to First Union's Wakeman, "synthetics are typically sold at a premium price for a tailored product. You always have some current to swim against, and as such, hedge funds aren't typically involved positioning such paper at all. There is also limited secondary trading in a synthetic convertible. Once it is designed and sold, it is usually just put away or eventually re-sold back to the issuer.” But for investors who need to own something that pays a coupon or dividend, or that have a convert-only mandate, or are looking for better NAIC reserve requirement treatment, synthetics can be a pretty nifty product. Index-linked bonds have even been launched in which a basket of stocks (instead of one stock) serves as the underlying for the convertible's option feature. One obvious fallout from such products is that one can separate the credit risk of a bond (now, typically, a Wall Street name) from the equity behavior of the convertible underlying. Traditionally, when the price of an underlying equity declines sharply, the implied credit spread on the convertible bond increases as well. An investor's exposure to an issuer is likely to be doubled up just at the wrong time. With synthetic convertibles, this risk is naturally bifurcated between the debt and equity components of the bond. The underlying stock may go to zero, but an investor still owns the senior debt obligations of a major Wall Street house. This year, there has also been a growing number of reverse-convertible issues coming to market. Here, an investor typically accepts all of the downside risk of a stock in return for a high current coupon, and some limited upside equity participation. Although few in the industry would refer to such products as a synthetic short in-the-money equity put, this is effectively the payoff profile that the investor captures. These kind of structures are most appropriate for investors who are extremely comfortable with the investment risks of being long a given stock, but who believe that the underlying stock's upside is likely to be limited. Sometimes referred to as a "capped common” transaction, reverse convertibles typically offer high current yields. The structure has been a particularly popular one in Japan, where pension plans struggle in the current super-low interest rate environment to achieve some income-producing domestic assets. —B.L.

More dangerous than Japan

Despite the obvious problems with the Japanese economy and ultra-low interest rates in that country, the Japanese market is probably less exposed to potential liquidity problems than the United States, says James Burns, founder and president of Aventine Investment Management, which specializes in Japanese convertibles. "The market structure in the United States is just inferior,” he argues. "Not only are the number of bonds below investment grade significantly greater in the U.S. than Japan, but on top of that, it's an over-the-counter market-maker structure, with liquidity being provided by all the large hedge funds, and these funds are typically all the same way until you hit a liquidity constraint problem. Then you get a black hole—an implosion. The U.S. convert market could easily be another disaster waiting to happen.”

"If mutual fund groups want to blow out $50 million in converts, it's not like blowing out $50 million in stock. I've never seen a situation where there is no bid in the U.S. market, but it has happened in Asia.” — Jeff Seidel, Credit Suisse First Boston

John Pagli, managing partner of global business development at Greenwich, Conn.-based Forest Investment Management, also sees a certain cyclicality to convertible bond arbitrage strategies, and concurs that liquidity can often disappear. While his fund typically keeps only 150 open positions at any one time, he explains, some of the larger convertible arbitrage funds may carry upwards of several hundred positions—and "once in a while, that's just too unwieldy to get out of.” In other words, convert bond managers can at times become deer frozen in oncoming headlights.

Burns believes we may be approaching the end of the greatest concomitant bull market in equity and fixed income in America's history. While people look back at 1990, 1994 and then the fourth quarter of 1998 and "try to explain away these periods as a ‘one-off events'” emanating from the Gulf War, Alan Greenspan's preemptive actions, the Soviet Union or Long-Term Capital Management, "for me, I've just seen liquidity crisis after liquidity crisis develop, and I think the next one is going to be more severe than the other ones.”

One potential catalyst for such a crisis, as he sees it, is that telecom companies are currently throwing money at their infrastructure build-out, and getting this money from convert issuance. "In some instances, the debt coverage may not really be there,” he speculates, highlighting default risks that few on Wall Street may be focused on today. "Japan is also subject to these risks, of course, but much less so,” he adds.

Taking an even longer-term perspective, Forest's Pagli feels that the current telecom debt issuance might someday end in a vale of tears—following the example of the Latin American debt crisis of the 1970s, the oil company overbuild, the savings-and-loan debt debacles of the early 1980s, and the leveraged buyout debt craze of the late 1980s. He is quick to note, however, that there are likely to be numerous profitable trading opportunities along the way.

Here is one possible disaster scenario: Assume convertible issuance steps higher into the fall, as most expect. Then imagine what would happen if hedge funds begin reducing their exposure to protect year-end returns, and insurance companies, concerned about FAS 133, also begin pulling out of the market. Add in a round of mutual fund redemptions—should the market, say, be disappointed by the Presidential election results—and things could turn downright ugly in a flash.

In this scenario, convert arbitrageurs, as the primary providers of liquidity to this niche market, could have the Janus Fund and the entire mutual fund industry effectively at their mercy—unless, of course, these managers don't see the mutual fund supply coming and are caught offsides themselves.

So far, the hedge funds have nicely avoided any major missteps within the Internet convert meltdown. Most telecom issues still remain above par. But if a similar telecom meltdown ever begins to transpire, let's hope the hedge fund managers are astute enough to see it coming—and set up their heavy hedges in advance once again.

The Boom in Euro-Convertibles

European convertibles used to be a geocentric market, with the currency exposure of each country always being an ancillary investment concern. Post the single euro, however, it is becoming truly Eurocentric, with 85 percent of new deals since 1999 having been euro-denominated. Also fueled since 1996 by low European rates and surging equities, the convertible market in Europe has grown at an annualized rate of 80 percent over the last four years (far faster than either the United States or Japan), and is now worth approximately $115 billion. The quality of the issues traded are typically far better than that in the United States, with technology, media and telecom convertibles still accounting for less than a third of total trading, but set to grow. Add to this equation the proposed capital-gains tax elimination in Germany on equity cross-holdings (due to take effect in its final form within the next three years) and the potential for huge convertible and exchangeable deal flow in Europe is staggering. "Everyone is excited about European converts and exchangeables, with justifiable cause,” says Viswas Raghavan, head of European and Asian equity-linked trading for JP Morgan. "First, the market received a liquidity boost post-euro, eliminating all the currency-induced barriers to investment. The strong performance of European equity markets has also shifted investor attention away from traditional fixed-income investing. Convertibles still appeal to Europe's historical fixed-income culture, while giving the ability to obtain equity market returns through a debt security. And now, with the capital-gains tax changes being introduced in countries like Germany, we will have an even stronger incentive for companies to issue equity-linked debt. Meanwhile, investors continue to prefer a defensive way to participate in the equity markets amidst all the prevailing volatility. European equity-linked issues, including exchangeables, should be a natural product to burgeon in the next two years.” The term exchangeable refers to a situation in which a given company issues paper that's convertible into another company's stock. By issuing a mandatory exchangeable with a maturity beyond three years, German companies will be able to monetize cross-holdings now, but without any immediate capital-gains tax liability now or later on. Will enough demand exist to absorb this potential waterfall of European supply? Both Morgan's Raghavan and Dariush Maanavi, a director in Merrill Lynch's equity-linked capital markets group, think so. "The capacity absorption capabilities of this market never cease to amaze,” says Raghavan. "Europe traditionally has had an appetite for straight warrants and principal-protected notes—driven partly by Switzerland,” says Maanavi. "But I see no reason an active exchangeable market will not emerge as well. We've already seen a number of large exchangeable transactions this year, and people are pretty excited going forward.” —B.L.