The ballooning spread between implied volatility and historical vol on some convertible issues could presage a meltdown in the convertible bond market or break the back of a number of convertible arb hedge funds, according to two European fund managers. Paul Besson, fund manager of the EUR220 million convertible arb fund at CCR Gestion in Paris, attributes the widening vol spread to the sharp rise in the number of convertible arb funds. These funds, he said, have bid up convertible prices to vertiginous levels. "It's like walking on thin ice," he said.
Convertible arb funds usually purchase convertibles in order to strip out the cheap embedded equity option, which they can then sell into the over-the-counter equity market. The problem many of these funds now face is the market has been so over bid that they have ended up purchasing the embedded options at a premium over the underlying market, making them difficult to sell. In addition, Besson said, stiff competition between banks for underwriting mandates in the primary market has driven issuers to price convertibles ever closer to par, rather than the traditional discount. "There's no free lunch anymore," he added.
For example, implied vol on chip manufacturer STMicroelectronics's USD650 million zero-coupon convertible of '09 was at 47% on Friday, versus historical vol around 30%. "If you hold this bond you're losing money every day on the time decay," Besson continued. CCR Gestion started shorting convertibles in February to position for the expected sell off, he added, declining to explain how the fund achieves this.
Christopher Davenport, director of convertible bond research at Schroder Salomon Smith Barney in London, believes the concerns are overdone, not least because longer measures of historical vol, which include the period around Sept. 11, may be distorting data for realized vol. In addition, some funds may be erroneously estimating market volatilities for notional options of similar specifications to those enbedded in convertibles. These are often so far out of the money that adjustments made for the skew can be overstated. Investors may also be overstating the implied volatility of the convertible--to one indifferent between buying and selling--by including stock borrowing costs in their calculations.
"There is a possibility of a large collapse," said Olivier De Lamotte, head of convertibles at the structured and alternative investment management group at AXA Investment Managers in Paris. AXA pared its risk exposure on the EUR200 million fund to around 15% last month--versus typical exposure of 25%--because of fears of a slump in vol.
However, De Lamotte is not convinced that a collapse is inevitable. What is more likely, he reasoned, is that fund of funds and direct investors pulling monies out of convertible arb funds--a trend that is already underway--will push these managers to sell bonds at unattractive levels, forcing them to realize losses. This, argued De Lamotte, will lead to consolidation among convertible arb funds. "In these troubled times the bigger you are the better you are," he said. "After a collapse people will come back to you because the small [funds] are dead."
