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Repeat of 2008 convertible bonds sell-off unlikely says RWC Partners

Wednesday, September 14, 2011
Opalesque Industry Update - David Basile, fund manager of the RWC Global Convertibles Fund, which lost 3% so far this year against stumbling equity markets, believes that although the environment is now very uncertain, there will not be a repeat of the sell-off in convertible bonds seen in 2008 – when the asset class behaved inconsistently.

The $200bn convertible-bond market had lost 36% by November 2008 reported the WSJ then, a bit more than the stock market. But the average convertible-bond hedge fund lost about 50% in that time, including a 35% plunge in October. Buying and selling convertible bonds is a bread-and-butter trade for many hedge funds, said the paper, and the market's decline hit some of the biggest ones, including Highbridge, Citadel and Jabre.

The HFRI Fixed Income-Convertible Arbitrage Index was down 2.39% (est.) in August 2011 and -2.62% YTD, after returning 3.73% in the last 12 months.

“The balance of convertible market participants in 2008 was skewed towards hedge funds using leverage to make a profit via volatility arbitrage versus long-only outright funds which invest based on fundamentals,” explains David Basile in an email. “The reduced availability of leverage and increased funding costs both negatively affected convertible arbitrage funds. These hedge funds became forced sellers of convertible bonds as positions became too expensive to hold, and they were required to deleverage. This was the key reason for the asset class becoming distressed in 2008.”

Long-only funds now the dominant players
But now leverage within the asset class is vastly reduced, he goes on to say. As indeed the most recent data indicates that the balance between hedge funds and traditional long-only participation has swung by 20% such that long-only funds are now the dominant players in the convertibles market.

And while the short-selling ban adversely affected the valuations of convertible bonds, currently, new short-selling restrictions will have a limited impact on convertible bond markets and valuations: “A number of European countries have introduced restrictions that are effective for limited periods and the UK, Germany and the Netherlands have announced that they are not introducing such restrictions for now. Additionally the more dominant role of long-only accounts combined with the lower leverage levels of arbitrageurs will constrain any negative impact on convertible bonds in the event that short-selling restrictions are expanded.”

RWC has compared equity market performance over the key stress period of September 2008 to the recent moves in August when the decline in equity markets was of a similar magnitude and found that the market composition is now much more balanced between long-only accounts and hedge funds, with long-only accounts being the dominant of the two. “This means that the asset class is structurally stable and is in a far better position to withstand pressure than it was in 2008,” Basile concludes.

It was reported on Monday that RWC Partners, an independent investment firm based in London, was to launch a hedge fund for Peter Allwright and Stuart Frost to replicate the strategy of the Macro Trading Crescendo fund they previously managed at Threadneedle. And RWC’ Head of Absolute Return Bond Strategies, Peter Allwright, said in May that investors should be far more concerned about the effects of the “re-profiling” of Greek debt than the inflation numbers.
B. Gravrand

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