Convertible arbitrage hedge funds are searching out ways of reducing credit risk while avoiding the high premiums associated with the credit-default swap mart, and some think equity derivatives are the answer. One of KBC Alternative Investment Management's convertible arb funds started using deep out-of-the-money equity puts to hedge against bankruptcy risk on convertible bond exposure last year and bankers predict this technique will spread this year.
Venu Krishna, U.S. head of convertible research at Lehman Brothers in New York, explained that over the past 18-months high default rates have led to increased demand for credit protection and therefore rising prices. In tandem, low volatility in the convertible bond market has led to fewer incremental opportunities, all of which has encouraged hedge fund managers to employ more variable strategies than simply hedging out their convertible bond exposure with credit-default swaps.
In order to boost returns, convertible arbitrage hedge fund managers began taking on correlation exposure between credit-default swaps and common stocks, noted Krishna. The period of easy returns in the convertible arbitrage market has ended and over the next year it will be difficult to use plain vanilla volatility orientated strategies as a vehicle for returns, he predicted.
In addition to hedging convertible bond positions, many hedge fund managers have taken on capital arbitrage positions, according to Martin St. Pierre, senior managing director and co-head of New York credit derivatives trading at Bear Stearns. This involves making relative value purchases on credit-default protection and equity, a trade which has similar characteristics to buying deep-out-of-the-money puts, he noted. One hedge fund that employs both strategies is Etolian Capital, a fixed income hedge fund founded by derivatives honcho George Handjinicolaou, former managing director and head of global fixed income emerging markets at Merrill Lynch in New York (DW, 10/13).
