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Making a comeback

01 May 2009

Convertible bonds as an asset class had one of the worst years in their history in 2008. Many of the losses were attributed to forced selling by highly leveraged hedge funds and the proprietary trading desks of investment banks. But these instruments are poised for a comeback. Joseph Mariathasan reports.

Convertible bonds last year were faced with no choice but to deleverage their portfolios with the ban of short selling, and the seizing up of the credit markets cutting off their supply of debt finance, whilst losses in other parts of their businesses meant they had to reduce the size of their positions. The nationalisation of the two US mortgage providers, the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) and the bankruptcy of Lehman Brothers were particularly significant as they were significant issuers and holders of convertible preferred shares. The effective destruction of the Fannie Mae and Freddie Mac convertibles together with the losses stemming from Lehman securities was a catalyst for a melt-down in the convertibles marketplace as a whole.

Before the deleveraging started in the summer of 2008, convertible arbitrage had been seen as a reliable and very profitable means...