Why have Convertible Bonds Underperformed?
Over the last 7 years, convert arbitrageurs have increasingly become the dominant participants in the convertible market, withmany such players holding similar positions. As a result, there are few buyers in the market when arbitrageurs start to sell enmasse. In addition, new issues were structured towards convert arbitrageurs, with lower coupons and higher premiums toincrease volatility exposure at the expense of lower outright returns.
Higher Funding Costs
Because convert arbitrage is a leveraged strategy, the increase in funding costs have hurt returns for most convertiblearbitrageurs. This has caused a sell-off since it became more expensive to keep positions on the books, particularly on “carrytrades” (deep in-the-money convertible trades and mandatory trades).
Lehman Unwind Trades
When Lehman declared bankruptcy, many commercial banks who had repo lines with Lehman received converts that werehypothecated to them as collateral for the repos. Since commercial banks were not active participants in convertibleinvestments, they sold these converts as they received it. This caused blocks to trade significantly below market prices thatput further pressure on valuations.
The NASD Trace reporting requirements increased visibility of trades to the market/ Therefore market reactions to trades(e.g. LEH unwind trades) exacerbated the selling. With each LEH block the entire market was repriced lower as all dealersand investor alike saw each price. Before the TRACE requirement, block trades would trade “in the hole” but bonds wouldsnap back after the trade and valuations would not be depressed for a significant amount of time. Now each block tradeprices the market lower, leading to more selling because of the following reasons:
Redemption Related Selling
With convert arbitrageurs returns negative 15+% YTD, many funds are starting to face (or are beginning to fear andprepare for) investor redemptions. This has led to more selling at depressed levels, putting further pressure onvaluations.
Short Sale Rule
The short selling ban on financials and other stocks adversely impacted valuations of the underlying converts.Because investors cannot initiate or increase short positions in the specified names, sellers of those converts areforced to sell into extremely low bids because arbitrageurs can not delta-hedge their positions. Valuation on thesenames because without the ability to short stock against the converts, there is no way for arbitrageurs to extract thetheoretical cheapness.