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THE RENEWED OPPORTUNITIES IN THE U.S. CONVERTIBLE ARBITRAGE MARKET
 

By Brian Stark and Michael Roth, founding partners of Stark Investments, a Mequon, WI based hedge fund with over $1.7 billion under management. This article appeared in the November 2001 issue of Hedge Fund News?.

At the onset of this year, after nine very, very good quarters for convertible arbitrage, there was a fear that a surge of new capital and managers would flow into the strategy, thereby chasing up valuations and exhausting investment opportunities

At the onset of this year, after nine very, very good quarters for convertible arbitrage, there was a fear that a surge of new capital and managers would flow into the strategy, thereby chasing up valuations and exhausting investment opportunities. However, the opposite of this capital flood scenario occurred, as an unprecedented wave of new convertible issuance swamped convertible investors. Through June, over $65 billion of new convertible securities had been issued in the U.S., eclipsing the total for all of last year. The reinvention, reinvigoration and replenishment of the convertible market that flowed from these new issues have set the stage for good performance in the months and years to come, while deep-sixing the capacity issues that had loomed menacingly over the strategy at the beginning of the year.

The issuance activity has been dominated by contingent convertibles, Wall Street's latest new, new thing (dubbed "CoCo's" by the ever-resourceful trading community). The contingent convertibility feature links the convertibility option of the security to the underlying equity rising in value to a specified level. Typically, the stock must rise 10% to 20% above the conversion price of the bond before the holder can convert into equity. The contingency also goes away in special circumstances, like a change of control.

From an issuer perspective, the convertibility trigger is extremely attractive because it permits the issuer to exclude the stock underlying the convertible from the calculation of its fully diluted earnings per share until the trigger level is met. Contingent convertibility is a negative from the investor's perspective, so the issuers have added put options that allow investors to recoup their investments in the event the underlying equity fails to rise. Most commonly, there is a series of rolling puts that enables the holder to put back the bond at par or some accreting premium to par on discrete anniversary dates, such as the first, third and fifth year after issuance. The issues vary widely in terms of the number and timing of the puts.

Another contingency found in some of the issues is a contingent interest payment feature. This feature makes any interest payment to the holder of the security contingent upon the price of the convertible climbing to a pre-set level. This structure creates certain substantial tax benefits for the issuers.

Finally, many of the new issues have combined the contingency features with a zero coupon format that affords issuers substantial cash flow benefits. This format is attractive to issuers because the accrued interest is a non-cash expense and they receive a tax benefit from the accrued interest expense. Because of the attached puts, companies are able to issue CoCo's with very low accretion (interest) rates (0-3%) and substantial conversion premiums (25-50%) for such low interest rates. The puts are viewed by issuers as an inexpensive add-on, given issuers' typically optimistic outlook for the future performance of their stock.

Very low coupons, healthy conversion premiums, significant cash flow and tax benefits, and no immediate dilution to earnings to boot, all add up to extremely attractive financing in the minds of issuers. It is no wonder that issuers have been coming to market with these structures in droves: "Since the first Tyco deal in November 2000, issues with some form of contingencies have accounted for $41 billion in proceeds, 55% of total issuance for over that period. Investment grade paper has swelled to 51% of the total convertible market, up from a low of 31% at the end of 1999." Convertible Special Report. Contingent Technology Has Revolutionized the Asset Class, (Merrill Lynch, August 9, 2001).

Outright convertible funds dislike this product. The coupons are too low and the premiums too high for their taste; they get too little participation on the upside and too little of that "paid while you wait" component of the traditional convertible. The press has quoted these critics as proof of convertible hedgers overpaying for product as they struggle to put to work the assumed torrent of capital pouring into their funds. We disagree. These critics are ignoring the extremely valuable puts attached to the CoCo's. The outright community discounts the puts because, being directional in orientation, the outrights place maximum value on upside potential. Because they do not hedge, the outrights cannot take advantage of the optionality of the puts by buying and selling the issuers' equity that makes up the hedge. For us, on the other hand, the CoCo's can be very attractive.

These instruments are issued by high quality, investment grade companies. The puts afford an additional defensive aspect to the security and provide us with valuable opportunities to trade around the optionality imbedded in the put by buying and selling the issuers' equity that makes up the hedge (i.e., they have "gamma" in the argot of the Street). These attractive characteristics hinge upon the puts holding their value over time due to the credit worthiness of the issuer. Accordingly, a premium must be put upon thorough credit analysis, both at the point of purchase and going forward. Several recent instances of purported investment grade companies falling from grace serve as a reminder that a quality staff of credit analysts is still a necessity for this strategy.

Like all convertibles, the CoCo's have attributes that can be more or less desirable. On the plus side, they come from investment grade issuers, meaning convertible hedges will carry much less credit risk than typically associated with more traditional U.S. convertible product. Their zero characteristics and attached puts add additional defensive characteristics, with these instruments being issued much closer to their bond floors. ("On average, the bond content in these issues is 83%, well above the 68% average for non-contingent structures." Convertible Special Report). This quality will provide significant support for the security in the event the equity takes a header. In addition, the issues have been coming with considerably more protection against being called back by the company than the traditional convertible. This is on top of the fact that zeros are often not called by companies, even after call protection expires, because of their cash flow attributes.

On the negative side, zeros introduce a higher degree of interest rate sensitivity and may have adverse tax consequences. These exposures, however, can be readily hedged and financed away. The most significant drawback of CoCo's is their "carry" aspect. Unlike the more traditional U.S. non-investment grade convertible arbitrage position, a hedged CoCo position features little or negative cash flow. Accordingly, these positions are much more dependent upon volatility to make profits than traditional convertible arbitrage positions, which benefit from a strong positive cash flow.

The key to whether the CoCo is a good buy, like any convertible, is whether it is cheaply priced. Because issuers are so eager to issue these instruments, and because so many issues are coming to market at the same time, many of the new issues have been available at very attractive valuations. The new convertibles are being issued, or soon trade after issuance in the secondary market, at implied volatilities that are at very sizeable discounts to the actual volatilities the underlying stocks have exhibited over the past three to five years.

The future looks very bright for convertible arbitrage given the events of the past several months. The opportunity sets in both the U.S. and Europe have been restocked with high credit quality paper, some of which is currently very attractive. The scramble for liquidity and the digestion of these new issues has created similar attractive opportunities in older existing issues in all of our geographic markets.

This leads us to examine the view that "convertibles are headed for a train wreck", as the only buyers of these instruments are convertible arbitrageurs. First, there continues to be very vibrant demand by the outright community for convertibles in Japan and Europe. It is really only with respect to the U.S. market that the issue is typically raised, and the estimate we most often hear is that roughly 70% of the convertibles are held by the hedge community. Even here, most of the concern is directed at the CoCo's, because the outright community continues to have strong demand for attractively priced, traditional convertible product. The appetite of investors for the recent Lucent and Nortel convertibles are but the latest illustrations of this fact.

Second, it should be emphasized that it is not per se a negative that the hedge community dominates the convertible marketplace. In most circumstances, at least from the standpoint of stability of capital and volatility of returns, this is a very positive circumstance. The market share dominance by the hedge fund community has come at the expense of the dealer community and outright investors. Historically, no one has been quicker to blow out positions and been a more destabilizing force in times of stress than the proprietary desks of the banks and brokerage firms. To the extent that these desks are more focused on new issuance, commissions and prime brokerage, and less upon competing for ownership of positions, the better. In terms of outright convertible investors, they are hardly paragons of stability. Equity oriented and not hedged, outrights tend to react like holders of stock and reduce their holdings when markets start wigging out. Because their concern is avoiding that next 10 or 20% hit when markets are cascading down, they become relatively insensitive to how quantitatively mispriced the security they are selling is at that moment. Convertible hedgers, on the other hand, are investors who make their living by building and holding well-hedged convertible securities. We seek to take advantage of stressful conditions by purchasing undervalued convertible securities, and to avoid being distress sellers. The various hedging activities we employ are designed to not only produce profits and protect principal in perilous periods, but posture our portfolios to pounce on positions purged by peers at such pressure points. The staying power of hedge funds, by virtue of their hedging, provides stability. Thus, to the extent that the presence of the proprietary desks and outright community has diminished, the amount of variability in the convertible markets has been reduced. Certainly, the strong performance of convertible arbitrage funds over the past year and a half of equity weakness has in part been due to the reduced weighting of those other types of holders.

The concern over a concentration of hedge funds holding convertibles also manifests itself as anxiety over a possible confluence of circumstances that might cause a significant portion of the hedge community to sell, as in 1998. Many things have changed since 1998. For one, there has been a significant change in the arbitrage community's investor base. In the past three years the institutional investor has become a much more significant presence. Our experience is that this money is a lot stickier than some of the high net worth money that previously dominated the industry. In addition, there have been significant changes in the practitioner's side of the business, positioning funds to hold their portfolios during a time of stress. Improvements in risk controls, liquidity terms, and security of financing from prime brokers are steps that we and others in the arbitrage community have taken since 1998 that should mute some of the consequences of a future liquidity crisis.

Moreover, the arbitrage community has been mushrooming in size and diversity. The notion of a monolithic hedge fund community all being forced to sell simultaneously is somewhat of an oversimplification. Many hedge funds are now multi-strategy in orientation, so if convertibles come under unusual pressure, they may be able to shift resources from other strategies. Even within the strategy itself, a distinguishing characteristic of convertible arbitrage is that it comes in several different flavors. It is certainly not news to seasoned investors in the strategy that different practitioners of the craft take a myriad of different approaches to the strategy. Convertible arbitrage managers may vary their implementation of the strategy along several different dimensions, including credit quality, geography, industry or sector focus, premium levels, liquidity, adherence to a strict quantitative trading style versus a more intuitive and experienced based trading approach, macro-hedging, degree of "market neutrality", etc. Accordingly, not all convertible managers are looking to do the same thing at the same time. In the end, however, if all funds are forced to sell, almost by definition, things will be bloody. This is an issue worthy of consideration and must be factored into any convertible arbitrage fund's calculation of how to construct its portfolio. What we have tried to show is that it does not necessarily follow from the accurate perception that hedgers have become the dominant force in the convertible markets to a conclusion that it is time to run for the hills.

With respect to the narrower issue of the CoCo's, the outright community has no appetite for this kind of security at issuance due to their low initial yields and high conversion premiums relative to those yields. However, they can become attractive to such funds down the road. The recently issued Calpine CoCo is an example. That company's stock has fallen from the high 50's at the time of issuance to the low 30's, raising the yield to put on this short dated instrument to a point that it has attracted outright buyers. Second, and more importantly, many arbitrageurs such as ourselves purchase the CoCo's under the assumption that we will never sell the security to another buyer. If we are buying it at a very sizeable implied volatility discount to expected future volatility, our plan is to extract our profit through volatility trading. If a buyer eventually shows up who is willing to pay much closer to fair value, that is a bonus, but not one upon which we are counting. Of course, in constructing our portfolios we must give significant weight to this potential illiquidity (though CoCo's currently are quite liquid in the hedge market). The reality, however, is that another governor typically is operative even before the liquidity constraint kicks in. The risk of future volatility proving to be lower than expected will typically limit the amount of this kind of paper funds will carry in their portfolios without offsetting positive cash flow paper.

In the final analysis, it comes down to a balancing of risk and expected reward. We believe the convertible market in general, and the CoCo's in particular, present a very attractive opportunity set. Their attractive valuations more than compensate us for what we believe to be an extremely remote risk of a mass exodus from the convertible market, given current macroeconomic and market conditions. At much less compelling valuations and/or under different macroeconomic conditions, our conclusion might be otherwise.

For some time, investors in U.S. convertibles have been concerned about the dominance of technology and telecom issuance, the proliferation of speculative credits, widening credit spreads, and the sensitivity of convertibles to increasingly turbulent equity markets. The events of the past several months have addressed these concerns about the U.S. convertible market. The issuance tsunami has led to a domestic convertible universe with a more diversified issuer base, better credit quality, and structures better able to withstand the credit weakness and equity swoons that have flowed from the current uncertain economic conditions. Such a change often comes at a price, as the market takes time to absorb and adjust to the new reality. To date, it has been a small price to pay for a reinvigorated U.S. convertible opportunity set. u

 
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