Although convertibles have traded around fair value or slightly expensive, many funds running directional money have been entering the arena in the last few years. Even if volatility is expensive in a certain name there may also be an end-buyer for that name who may be focused mainly on equities, for example, but who wants to own the convertible rather than pure equity. Fixed income managers are also actively seeking a ‘kicker’ from credits, which means that the whole market will not look to exit simultaneously.
Convertible bond arbitrage funds have had an interesting few years of late. Figures from hedge fund database provider Tass Tremont showed convertibles suffered $1.8bn of withdrawals in the first quarter of 2005 – the most redeemed hedge fund strategy over that period – while the HFRX Convertible Arbitrage Index, tracking performance of convertible bond arbitrage hedge funds, fell 2.41% in April 2005. The average convertible hedge fund returned 3.96% in 2005, according to Tass Tremont.
The downturn in convertible bond arbitrage from 2004 to May 2005 stemmed from a number of issues. There was a preponderance of hedge funds as investors in the market – a state of affairs that, as mentioned, has since changed somewhat – leaving fewer other end-users. Figures suggested have cited up to 80-85% of the market’s convertible issuance had been held by hedge funds. In addition money had flowed into convertible bond arbitrage on previous good performance, pushing valuations up to excessive levels.
Fast forward to May 2007 and convertible bond arbitrage returned 14.95% in 2006, according to figures from Eurekahedge. While some of this will have come from convertibles being valued lowly in general, skill from the better managers has also played its part. Admittedly, the 2005 first half sell-off may have helped those managers who were not forced to close before it rebounded, but convertibles have been anything but purely a ‘value play’.
Convertible funds had performed well for a number of years before the big sell-off, not always necessarily from volatility trading. At Augustus Asset Managers Limited we look to employ a strategy within convertibles that can perform in all types of markets and although the JB Convertible Bond Hedge Fund we manage was not established until July 2005, we believe the structuring of its portfolio could have seen it weather the storm from April-May 2005. Why? We want our convertibles hedge fund to be long volatility and long delta, and be a relatively high gamma portfolio, so if/when the market corrects we may lose money the first 2-3% of that correction through delta, but after that the gamma portfolio takes effect, and from that point down we are making money.
The gamma portfolio of the fund and almost all our credit exposure is hedged out. We like to buy index protection against the portfolio and index protection options, which are liquid. Every six months we look to spend premium to protect the portfolio, which typically has 35-40 different names in the portfolio, each with several legs.
There are a number of other lessons we have had the benefit of learning, without having to have put our portfolio and investors through the difficult markets of 2005. The first is to avoid your convertible bond hedge fund being too concentrated. One fund buying 30% of an issue, for example, adds to illiquidity and trouble on aggressive selling, especially as you travel down the credit curve. If you also have ‘fast money’ in your fund it can be very dangerous.
At Augustus Asset Managers Limited we have a 10% concentration limit of investments in any one issue and we can liquidate our whole portfolio within a week. Following this theme of diversifying, we are also investing where fewer of our peers do – for example, in Asia and Japan where we are bulls on equity markets and where there is a lot of issuance. In addition a lot of the Asian markets are becoming more developed in respect to borrowing stock synthetically, which provides opportunities. Credit markets have also developed in these regions, offering opportunities.
In Asia we are keen on the Malaysian stock market, for example, where there has been a lot of issuance over the last six to nine months. Although the stocks there are relatively low volatility stocks they’re essentially directional type trades, ones that tend to trend and come back over time. Raffles Telecom was an issue that came to market in Malaysia in September. While not necessarily the cheapest trade, it offered little downside and good opportunities on the upside, and paying away 20% over five years. We do not exclude the US markets from our portfolio, but they are quite crowded. We feel better opportunities are to be had elsewhere. Currently the portfolio is split about 35-40% in European issues, 30% in Japan, 25% in Asia ex-Japan, and the balance in the US.
At Augustus Asset Managers Limited we are often asked about convertible funds’ correlation to equity markets, which can be a problem for investors who want a diversifier. In May 2006 equity markets were down around 10-14%, and the Nikkei fell 20%, while our fund was up 3%. Our portfolio has sufficient protection at the single name level, and we hedge the book on a macro basis as well. We can only run 30% of the NAV as equity market exposure and while we want to have some equity exposure, we are not looking to bet the house on it. While we have stuck to our process, investors have seen other convertible funds reinventing themselves as multi-strategy funds, some have invested in credit rather than buying credit instruments to hedge out their convertible portfolio. This is acceptable – as long as you have the experts with the appropriate background. We have set ourselves up specifically to run a convertible fund. Investors in our fund will not find us trading various credit strategies – we would not start buying corporate bonds and buying protection, that is what credit funds do.
While the JB Convertible Bond Hedge Fund is not limited to US and European markets, nor is it purely a volatility fund, nor purely directional. We feel it would have made money in the volatility sell-off in 2004-2005, as one would have seen relatively strong equity markets and the fund would have continued to make money in the relatively strong equity markets.
Credit’s good year last year may leave some wondering if they should market-time and exit the strategy. We are personally bullish about the convertibles market. In Europe we are seeing large amounts of M&A, and most convertible issues in Europe have some corporate event protection whereby convertible holders outperform equity holders on a market-neutral basis in takeover situations. In addition, skilled convertible managers will often be in a trade due to the undervalued nature of the stock before any event is announced, unlike merger arbitrage managers, and we will unwind the trade if the deal is announced.
Ben Helm is Fund Manager of the JB Convertible Bond Hedge Fund, Augustus Asset Managers Limited