Convertible value recovery not helping volumes

Wednesday, October 27, 2010 Stamford, CT USA — A recovery in the valuations of convertible securities held in the portfolios of institutional investors in the United States and Europe has not translated into a pick-up in trading volumes, which continued to decline from 2009 to 2010.

The recovery in global equity markets and the tightening of credit spreads around the world last year helped restore the valuations of institutional convertible securities holdings by some 20% in the United States and Europe. Despite the growth in AUM, the results of Greenwich Associates' 2010 Convertibles Investors Study reveal that average institutional trading volumes in convertible securities declined by 10% from 2009 to 2010 in the United States and by 25-30% in Europe.

Relatively low levels of new issuance contributed to the trading slowdown in 2009-2010. In addition, many of the trades that were executed in 2008-2009 involved opportunistic "cross over" buyers — many of them outright funds — looking to take advantage of what they saw as historically attractive valuations on convertibles. The restoration of valuations to more "normalized" levels from 2009 to 2010 brought an end to this wave.

A Diminished Presence for Hedge Funds
Specifically for the U.S. market, this trend also meant that outright investors now account for a significantly larger portion of the convertible asset holdings, having replaced investment capital from some hedge funds that have either de-levered or left the convertible space altogether. In 2007, outright or long only investors made up only about a quarter of the total number of active convertibles investors tracked by Greenwich Associates in the United States; today, they make up 45%.

Attrition among dedicated "convertible arbitrage" shops and other hedge funds helped shrink the presence of hedge investors in the U.S. market. Also contributing to the reduced influence of hedge funds in both the United States and Europe was a sharp decline in leverage ratios. After peaking in 2007 at 3.4:1, leverage ratios for U.S. hedge funds declined to 2.9 in 2008 and dropped to 2.4 in 2009. Over the past 12 months they have crept back up — but only to 2.7. Hedge fund leverage levels peaked in 2008 in Europe, also at 3.4, but dropped to 2.4 in 2009 and fell again to 2.2 in 2010.

"With the tepid pace of new convertible issues and richer valuations of existing securities, hedge funds are not seeing opportunities attractive enough to warrant the types of leverage levels seen in 2007 and 2008," says Greenwich Associates consultant John Feng.

Institutions' plans for future asset allocation suggest that new investment capital may flow into the convertibles market in the coming year — and that U.S. hedge funds might soon begin rebuilding their presence in the market to some extent. In the United States, 38% of institutions active in convertibles — including 43% of hedge funds — expect to increase the proportion of their total capital devoted to the product, with only 6% planning a reduction. Forty-five percent of European institutions active in convertibles expect to increase the proportion of their total capital devoted to the market, with only 3% planning a reduction. Whether these expectations translate into reality will depend to a large extent on the availability of new issues.

Greenwich Leaders: U.S. and European Convertibles
Deutsche Bank and Barclays Capital have built a significant lead over competing brokers in European convertible bond trading, with Deutsche Bank amassing an estimated market share of 17.3%, followed by Barclays Capital at just over 16%. In the more fragmented U.S. convertible market, the following firms all have earned market shares of at least 10% of institutional convertible trading volume: Bank of America Merrill Lynch, Credit Suisse, J.P. Morgan, Goldman Sachs, Deutsche Bank, and Citi.

Investors in European convertibles give the highest quality ratings to Deutsche Bank's overall capabilities while Bank of America Merrill Lynch earned the recognition from investors for U.S. convertibles.

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