Financing for "arbitrage" strategies

Rookie_Quant · Post by **Rookie_Quant** » Wed Oct 22, 2008 6:59 pm

Given the turmoil in convertible bond markets of late, I've heard rumblings of various PBs exiting the convertible "arbitrage" financing business, and I also know that various equity strategies done through TRS are effectively closed.

If you are an equity trader (in these specific industries...MLPs would be the best example) or convert guy, is there any way to replace that source of financing, or are those types of trading strategies completely dead?

Cheng · Post by **Cheng** » Thu Oct 23, 2008 9:11 am

I am not into convert arb but I thought this business has been more or less dead for quite a while (low issuance, low vol). Can anyone add some color here ?

FDAXHunter · Post by **FDAXHunter** » Thu Oct 23, 2008 9:19 am

Convertible arbitrage traders are getting murdered. The HFR Convertible Arbitrage Index dropped 12% in September and is down 20% YTD.

One of the biggest (the biggest?) Convert Arb traders, CQS (considered for many years to be one of the best hedge funds out there), is down 20% since its peak in October 2007.

Jaxx · Post by **Jaxx** » Thu Oct 23, 2008 1:42 pm

Those are not the worst numbers from big (even three letter) cb funds that i've heard. valuations have dropped through the floor and there hasn't been a great deal of liquidity, not surprising given the current market conditions.

Those numbers from CQS aren't "relatively" that bad, although they've always been more conservative and better hedged than a lot of the punters out there. (edit; I don't think they are the biggest out there, probably top 5).

Rookie_Quant · Post by **Rookie_Quant** » Thu Oct 23, 2008 4:58 pm

I can confirm (thankfully NOT through a NAV statement of my own) that some convert guys are down north of 40% this year, and many more are about to start the gating process any day now.

The low vol issue is sorta perverse if you think about it. I've thought CB arb was dead for a few reasons, but the main one being that most people use it as a vol strategy, and when you get really significant vol, it's not exactly there to help you. It's dominated by too many other factors. I know alot of people in allocation seats poured into the strategy expecting volatile time periods. THey got more than bargained for.

But irrespective of that, if the arb guys cannot finance positions, that only leaves long-only folks to take down supply, and that isnt a good prospect for demand/supply balances IMO.

Jaxx · Post by **Jaxx** » Thu Oct 23, 2008 5:18 pm

I think the biggest issue is that because there have been so few opportunities over the last 5 years, the biggest guys have really had to slide down the liquidity spectrum, ie owning 50% of $200mm issues and doing private issuance where they own 100% of a $50mm deal of some tiny asian company, whether the stock is listed or not. I've seen a lot of this paper being shown around at huge discounts. I guess its been too crowded an asset class for too long, although I think this is true for any "arb" strategy.

kr · Post by kr » Sat Oct 25, 2008 12:16 pm

The cb stuff I've looked at lately - out of Asia - is really aswp business and not vol business, and I'd guess similar prefs-type business out of Europe is the same. The issuers of this paper are getting smoked on a credit basis so any conversion option is miles away from where vol matters. And if you think of aswp finance as neg-b trading, then mkt levels for neg-b have also exploded b/c the banks have zero cash to lend anyhow. I would probably have to charge upwards of L+300 for neg-b now, if I could be in the business at all... that probably means hedge fund IRRs would automatically be 10% lower if they entered new trades TODAY, nevermind the hammering they've already gotten (and will continue to get as company valuations fall).

Kitno · Post by **Kitno** » Sat Oct 25, 2008 2:21 pm

CB asw business in Europe is dead. Why use BS for something with such asymetric risk - you're not getting called anytime soon nor will you see an LBO and there is absolutely nowhere to lay off the CBASW - those buyers blew a year ago. Far better uses for BS with more upside and liquidity. Even just hedging their credit with CDS is hard. I don't want to lose 500 running and be left long protection at these levels (goodbye CCDS too).

Having said that owning CBs outright looks incredibly attractive vs the issuer's straight debt now. To name the most obvious: KfW 13s CB @ L+80. While the majority of the jamboree, like RM accts, can't buy CBs (even with a 'zero' option value) there's still no bid support. Distressed guys who've started to come in should wait till the first big CB fund unwinds (looking like next month).

EDIT: Above I was referring to the credit attractiveness of pari passu senior unsecured CBs vs same issuer's senior unsecured straight debt - not subordinated/pref trash.

Rookie_Quant · Post by **Rookie_Quant** » Sun Oct 26, 2008 5:53 pm

Spent much time lately trying to uncover who the ultimate bidder will be for some of these CB securities. I cant reconcile the supply/demand at a very simple base level. If I'm a distressed guy, and all of my usual markets are imploding (bank loans, structured credit, etc.), what is my incentive to screw around with CBs?

Traditional CB guys are STILL trying to express how crazy a "zero option value" is, despite the fact that the delta is far from being meaningful.

What type of average rec rate assumptions go into the CB part of the capital structure anyway? It seems like CBs have low coupons, lots of subordination, and no natural buyers...not to mention a slew of coming liquidations and no financing to speak of.

Johnny · Post by **Johnny** » Sun Oct 26, 2008 7:34 pm

There are probably lessons to learn here from the 97/98 Asia crisis during which the majority of the Asia ex-Japan CB universe traded at zero option value. The two games in town were (1) asset swapping to commercial banks and (2) repurchasing CBs for the issuers themselves. Of course, both of these require that banks and / or issuers have capital that they are willing to commit, so they were trades that became big as Asia recovered from crisis. In the early parts of the crisis, the buyers were fixed income funds looking for Asian corporate credit exposure. For obvious reasons it's unlikely that those buyers will be around this time. So my guess is that CBs fall even further than last time, leading to substantial repurchase opportunities for issuers earlier in the cycle.