Equity-linked: Synthetic convertibles move into the mainstream


Peter Koh
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A shortage of primary convertibles issuance has moved synthetic convertible bonds out of obscurity and into near ubiquity among European institutional investors.

"Due to a shortage of corporate convertible bond issues in the European market, investors have turned to synthetic convertibles in droves, particularly outright (non-hedge fund) investors," says John Feng, a consultant at Greenwich Associates, which conducted a recent study of the market.

According to Greenwich, almost 95% of long-only European institutions now invest in synthetic convertible bonds, while the proportion of hedge funds investing in the product is 22%. As a share of these investors’ total convertible bond holdings, synthetics now account for 16%, up from 10% in 2006. Among outright investors using synthetic convertibles, synthetics make up 17% of their convertible holdings, up from 12% last year. Moreover, over one-third of synthetics investors expect to increase their holdings over the next 12 months, as do 14% of hedge funds not already holding the product.

Strategies changed

The study also found that investors in Europe and the US have largely changed their convertibles investment strategy since 2005, when the market reached a low point. That market downturn caused the demise of several dedicated convertible arbitrage funds, and as hedge funds return to convertibles, they are spurning dedicated approaches in favour of more diverse multi-strategy structures that incorporate convertible arbitrage as just one strategy of several.

European convertible bond investors typically dedicated 25% of their assets to convertibles in 2007, down from 40% in 2006. Among hedge fund investors, convertible bonds have fallen to 29% of total assets from about half in 2006. "Only 10% of the investors in European convertible bonds are what you might call dedicated convertible investors, which have more than 80% of their total investment capital in convertibles," says Feng.

Poor liquidity remains a significant obstacle for some. According to Greenwich, 85% of investors said they would like to see multiple market makers in large synthetic issues.