The Alexandra Global Investment Fund has entered an asset swap on the back of a convertible bond it recently purchased. The manager bought USD5 million of three-year Hutchinson Whampoa bonds, exchangeable into shares of Vodafone Group. It then essentially stripped out the embedded equity option and sold the bond to a special purpose vehicle, said Mikhail Filimonov, managing partner at Alexandra Investment Management, the investment advisor for the fund in New York. It sold the bonds at a value such that they could be swapped into synthetic floaters paying LIBOR plus 165 basis points.
At the same time, the dealer entered a cancelable interest-rate swap with the SPV in which the special purpose vehicle pays fixed and receives floating. The SPV issued floating-rate callable notes.
If the fund exercises the embedded equity option, it can purchase from the SPV the bond at LIBOR plus 155bps. The asset swap has a one-year maturity, after which the fund can roll it over, according Filimonov.
The asset swap hedges out the credit and interest-rate risk of a bond for the fund--the fund effectively holds only the underlying equity option. The fund is only interested in the embedded equity derivative, and does not wish to take a view on the future direction of interest rates or the company's credit, particularly with recent interest rate volatility, said Filimonov.
The bond was interesting because it was trading at a 1.5% discount to its theoretical value, according to the fund's model, which takes into account factors such as the implied and historical volatility of the underlying equity option and the yield on the bond, said Filimonov. The fact that the bond is relatively short-dated, and issued by a high-quality name with a volatile underlying equity, means that the fund has a relatively low credit risk to hedge, and high potential upside from the underlying equity option.
John Burke, managing partner at Rumson Capital, a hedge fund in Red Bank, N.J., said that in general convertible bonds issue at a discount to their theoretical value as an incentive for investors to buy the securities. Issuers like convertibles because they pay lower coupons and allow the company to sell equity at a premium. But in order to attract investors, the bonds need to be priced at a slight discount to the theoretical value of the individual components of the bond. The asset swap passes along some of this discount to investors in floating rate paper, and lets the convertible arbitrageur hold on to some of the discount as well.
The bond sold at a conversion premium of 30%, at an issue price of 99 3/8. One bond is convertible to 214.51 ordinary shares of Vodafone.
The Alexandra Global Investment Fund has a portfolio of USD500 million, and is a market neutral fund focusing mainly on convertible arbitrage.
