While everyone tries to determine exactly who lost what in the great VW squeeze, it might be useful to refocus attention on one of the great hedge-fund strategies that may have presented shorting VW common stock as a good idea.
Dennis Gartman of the Gartman Letter writes:
We shall not add to the rumours and shall not note names here, but suffice it to say that hedge funds and broking firms here in the US and in Europe are rumoured to be on the short side of VW common shares and the damage shall run to the billions of EURs. Porsche AG has suddenly become the largest winning hedge fund of the day, for it controls nearly all of the free float of Volkswagen, while everyone else is short of the common in any number of supposedly sophisticated hedged positions against VW convertibles, or VW debt issues.
So did convertible arbitrage have a role?
According to reports the big trade that caught out the hedge funds was actually shorting ordinary shares versus preferred. As Bloomberg reports, the trade failed when ordinary shares effectively controlled by Porsche sky-rocketted and the differential between the two widened the wrong way – the pref falling some 14 per cent on Tuesday.
Meanwhile, going long convertibles as Gartman suggests would not have been easy. This is because most of VW’s convertible issue is exclusively available to employees.
But perhaps the affair is a warning to the convertible arbitrage industry at large? According to the FT, financial companies sold more than $35bn of convertible bonds in the first nine months of 2008. A lot of this paper was presumably gobbled up by hedge funds keen to get back into the play, which had sizzled out post-2005 due to lack of issuance.
While the return of convertible arbitrage was the trade of month for hedge funds early this year, things haven’t been going so well of late. The Barclays Convertible Arbitrage Index shows September’s fund performance was the worst this year – down some 9.54 per cent.
Largely responsible for this, as the FT points out, was the re-weighting of risk in the market alongside the inability in many cases to short the corresponding shares because of regulatory curbs. Concept of value reportedly also left the market as a rush of fund redemptions forced block-selling of convertibles in some cases.
But maybe there is some reason to be optimistic? Traders report that for the first time in a long while the market staged a turnaround on Wednesday. The view is that as TED spreads and LIBOR levels come back to reality convertibles may once again prove attractive.
The securities could also prove attractive to more than just convertible arbitrageurs. As previous investment-grade converts are now trading at distressed levels, in some cases yielding as much as 14 per cent, the market is ripe for junk investors to pile in. The trade could also be of interest to traditional investors eyeing a return to equity markets, offering as it does a respite from immediate performance on account of the attractive fixed return.
Reuters quotes the head of wealth manager Salm-Salm & Partner in Germany as saying:
“It is a very favourable situation to enter the market now,” Michael zu Salm-Salm said.
“A lot of hedge funds have invested in convertible bonds, but had to sell them due to failed strategies and the short-sale ban,” he said. “At the moment you can expect a yield to maturity of about 6, 8, 10, even 12 percent and more, subject to the condition that the debtor does not go bankrupt.”
For convertible arbitrageurs though the risks certainly remain, eg. any renewed short-selling bans, credit downgrades or even a lack of liquidity.