The following article is written by Mike Roth, a founding
partner of Stark Investments, as a response to an article
on Convertible Bond Arbitrage appearing in Eurekahedge's
October monthly issue. Stark Investments specialises in global
multi-strategy arbitrage and is the manager of the Stark Japan
Fund.
An old Japanese proverb reminds us that "The reverse side also has a reverse side." After reading the article on convertible arbitrage in the October issue, which effectively fragged the entire Asian convertible arbitrage market and left it muzzle down in the mud, we felt it was time to turn over the body to see if indeed the strategy is paws up. We are happy to report that the rumors of its demise are somewhat exaggerated. In particular, it is inappropriate to lump Japanese convertible arbitrage in with the pack of mutts that pass for convertible arbitrage in the rest of Asia.
To judge the state of convertible arbitrage in Asia based upon developments outside of Japan is the epitome of allowing the tail to wag the dog. In Asian convertibles, Japan is still indisputably the Big Dog (even if its economy remains a bit of a sick puppy). Many of the observations in the October article on problems in Asian convertible arbitrage, while perhaps apropos to convertibles outside of Japan, are not applicable to Japan.
The October article argued that a litter of issues were currently dogging Asian convertibles, including illiquid markets, a lack of new issuance, high leverage, low gamma, redemptions, currency exposure, credit hedge exposure, and, no doubt, high cholesterol. A quick analysis of the Japanese convertible market shows that none of these concerns are applicable to Japan.
Non-Japanese Asian convertibles are not incredibly liquid under the best of circumstances, so it is not surprising that liquidity has further suffered during the equity and credit storms that raged this year. Liquidity in Japan has been good for the most part throughout the year, as befits a market of its breadth and depth. The multitude and quality of investors in the Japanese convertible market dwarfs that of ex-Japan Asian convertibles.
While it is true that new issuance in Asia (both in and out of Japan) has been poor for some time, ironically there have been a surprisingly large number of new issues in Japan in the past several months. Moreover, new issuance is less important in Japan than in some of the other Asian markets because the Japanese secondary convertible market is still one of the largest in the world. Certainly, the long-term viability of the Japanese convertible market will depend upon a resurgence in new issuance, but that is not a near-term problem.
Most of the other observations are similarly misguided in the Japanese context. There are no formal (or should we say reliable) measures of manager leverage, but anecdotally our investors tell us that the use of leverage is down across the board in Japan (certainly that is the case in our funds). This decrease has been driven by both defensive and offensive concerns, as funds assume more conservative postures during stressful market periods and accumulate buying power to hopefully take advantage of opportunities created by the market carnage.
While "low gamma" sounds like an explanation for why Godzilla feels sluggish these days, it relates to the concern in convert arb circles over the decreasing equity sensitivity (and thus volatility trading opportunities) in convertibles, as the prices of their underlying equities continue their search for the bottom of the market (which increasing looks like the Marianas Trench). The lament over the lack of equity sensitivity is doubly ironic in Japan because Japanese convertibles currently offer the most equity sensitivity, and thus volatility trading opportunities, of the big three convertible markets.
The author of the October article noted that the lack of equity sensitivity has turned convertibles into pure debt instruments. Whatever the situation in Greater Asia, it is highly unlikely that funds would hold Japanese convertibles, with their microscopic yields, for their value as debt instruments. Indeed, the continued robustness of the Japanese convertible arbitrage market, despite their "yield-challenged" status, is a testament to the volatility trading opportunities that persist in Japan.
As proof of the transmutation of convertible arbitrage into high yield, the October article discusses how credit derivatives are used by yield buyers to hedge credit risk. This is a classic case of correlation being confused with causality. In Japan anyway, convertible arbitrageurs have long used credit derivatives to hedge credit exposure. So little should be read into the increase in the use of such credit hedging instruments.
Potential redemption pressure is always a concern during difficult macro-economic and market periods, but Japanese convertible arbitrage has performed reasonable well over the past few years, so there is no reason to expect a run on the bank at year end (when it comes to runs on banks, the Japanese have much bigger fish to fry). Furthermore, for reasons outlined above (low leverage, liquid markets), should redemption pressure develop it would be readily handled by funds.
Concerns about currency exposure are a bit puzzling because any convertible arbitrage manager worth his (or her) Ken-L Rations can hedge currency exposure as a matter of course. Any hand wringing over dollar denominated convertibles is further moot in Japan, which is dominated by yen denominated issues.
As for high cholesterol, Japan is famous for its fish/rice diet driven low cholesterol levels (though we are somewhat anxiously monitoring the proliferation of Mickey D's in the Land of the Rising Bun).
We do agree wholeheartedly with the final point made in the October article related to the need for investors to evaluate the quality of a portfolio (and the manager for that matter) and the liquidity of the portfolio, and to beware of funds that offer too much liquidity to investors. It has always been so. While many investors reflexively prefer greater liquidity, this can come back to bite investors (both those coming out and those staying in) if a manager is forced to sell at the wrong time.
As long-time investors in Japanese convertible arbitrage
(with over 14 years of experience), we feel that the Japanese
market must be distinguished when discussing any possible
malaise currently infecting Asian convertible arbitrage. Convertible
arbitrage is alive and barking in Japan. Good boy!
