Bump in the Road for Convertibles

Hedge funds are selling off their holdings, adding to the risk of issuing these hybrid securities.

Convertible bonds are under selling pressure and suffering price declines as hedge funds seek to reduce their risk positions, according to Wednesday’s Financial Times. The issues of automakers and financial services firms are particularly affected.

Hedge funds drive much of the appetite for convertibles. They use convertible bonds for the purposes of arbitrage, buying the bonds then selling short the common stock of the issuing companies.

But hedge funds are putting more of their holdings in cash — 15% of assets under management at the beginning of 2008, according to Greenwich Associates — and deleveraging. Hedge fund industry leverage ratios fell to 2.1 at the end of 2007, down from 2.3 a year earlier, Greenwich says.

Among the hardest-hit convertible bonds on Tuesday were those of Wachovia, Bank of America, AIG, and Ford, according to FT.

A convertible bond can be exchanged for shares of stock in the issuing company, usually at a pre-announced ratio and at a certain price. They allow investors to participate in equity upside, while giving the company raising funds a lower interest rate. As a bonus, the interest is also tax deductible.

Sales of such securities have jumped in the United States the past two years. Volume fell to $52 billion in the first half of the year, down from $55 billion a year earlier, according to Thomson Reuters. But in the second quarter convertible sales increased to $35.2 billion, up from $29.7 billion last year.

The convertible bond selloff is only the latest caution flag to potential corporate issuers.

Because most convertible bonds are “putable,” the issuer can be forced to buy them back at a certain date and price if the company’s stock is trading out of the money. If enough holders do that, and in the meantime interest rates have soared, raising new capital could be much more expensive.

These bonds also often are putable when a fundamental change occurs in the business — so at the exact time a company may be having a financial crisis, it could be forced to pony up cash to buy back the bonds. Last March, Merrill Lynch had to increase the debt-to-equity conversion rate for existing bondholders and add more “put” dates so it wouldn’t have to lay out the cash to buy back its convertibles.

Homebuilder WCI Communities is also in a crisis related to its convertible bonds. Strapped for cash, the Bonita Springs, Fla.-based company is offering to exchange new secured debt with a 16% coupon for $125 million of convertible notes. Holders of the convertibles recently indicated that they would exercise their option to be repaid.

Issuance of convertibles can also cause a company’s share price to dip, because when a convertible matures, the company usually has to issue a large chunk of new stock, diluting current stakeholders.

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