Convertible bonds – especially for auto companies and financial firms – suffered sharp declines on Tuesday amid forced selling by hedge funds specialising in such securities, market participants said.
Convertibles – fixed-income securities that can be converted into shares – have been a popular way to raise capital in recent months, particularly for carmakers and financial groups such as Lehman Brothers. Such securities have been sold in the public market and placed privately to sovereign wealth funds and other investors.
Many hedge funds and the trading desks at Wall Street firms have been buying convertibles as part of a more elaborate trading strategy in which they also sell short the shares in the issuing companies – particularly in the troubled financial sector.
However, this trade has gone wrong recently for a number of reasons. The rout in the stock market has wiped out the value of the options in the securities that give investors the rights to convert them into shares. At the same time, it has become more expensive to borrow shares to short, changing the economics of these trades.
“Holding financial converts had been the trade of the month,” says Charles McNally, a managing director at Lyster Watson & Co, which invests in hedge funds on behalf of its clients. “Now everyone is cutting their gross positions. The deleveraging which has been going on for a year is continuing.”
On Tuesday, hedge funds that were either forced to sell or wanted to reduce their risk positions were offering blocks of convertible bonds worth several hundred million dollars, dealers said.
Fore Advisors, a convertible bond specialist with several billion dollars under management, was a big seller, dealers said. Fore declined to comment. Until the end of May, the fund had been up 5 per cent for the year.
Wachovia’s convertible bond was among the hardest hit, dealers say, with Bank of America, AIG and Ford convertibles dropping as well.
June was a bad month for hedge funds specialising in convertibles and dealers say July could be far worse. Until the end of May, convertible funds had enjoyed a respectable performance.