European hedge fund managers were left hopping mad last week after Boussard & Gavaudan Asset Management recalled a convertible bond it had loaned them via the repo market and which they had subsequently shorted. As a result of the recall of bonds issued by Italian corporate Finmeccanica, implied volatility on the bond jumped on June 24 and 25 some 350 basis points to 40%. This dramatic move, which some traders likened to a perfect storm, sent funds that were short scrambling to buy back Finmeccanica bonds to close out loss making positions.
Emmanuel Boussard and Emmanuel Gavaudan, fund managers at BGAM, did not respond to repeated calls to the firm's London and Paris offices.
Although prime brokerage agreements allow for securities to be recalled, a recall triggering a spike of this magnitude is unusual said officials. "The price action we saw was a several standard deviation move resulting from extraneous trading factors beyond normal market practice," said Luke Olsen, convertible bond research analyst at Barclays Capital in London. Market makers said the rise in the price of the bonds was so dramatic because BGAM had a large position--estimated at 40% of the EUR500 million (USD608 million) 2010 Finmeccanica convertible bond issue--loaned via its prime brokers: Goldman Sachs,Morgan Stanley and Deutsche Bank. Simon Eaton, spokesman for Goldman Sachs, Eva Hoeffelman, spokeswoman for Deutsche Bank, and Andrea Bothamley, spokeswoman for Morgan Stanley, declined comment.
Rival managers admit it is not clear whether BGAM was aware its prime brokers had loaned the paper, which officials say brokers are free to do so without informing funds under standard brokerage agreements. Michael Hintze, chief executive of CQS Management, which has USD2 billion under management, said it had a short position in the bond recalled by BGAM. He added that although this triggered a loss the fund had made a profit from shorting the bond prior to the recall. "It was not material month-on-month," said Hintze. "If you are shorting anything, you need to have good pricing and risk control," he noted, explaining that a potential recall is something funds borrowing bonds should consider.
In the short term this is likely to slow down the growing repo market in convertible bonds. "This example is likely to put people off [borrowing convertibles]," said one hedge fund short seller, who had been burned in the trade. In the longer term the squeeze might threaten liquidity if market makers are reluctant to go short convertible bonds, according to one convertibles trader.
