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Credit, Bonds, Derivatives



The convertible bond market seems like the place to be right now, both for hedge funds and corporate issuers. But like any hot spot, when does it become too crowded?

Every day there are several companies issuing new convertible bonds. It seems the refinancing of America is taking place in this one little arcane place. A strange symbiotic relationship has developed between hedge funds, brokers, and companies and a circular phenomenon is fueling the expansion: companies issue bonds at prices so that brokers and hedge funds can make money, which causes the hedge funds to make good returns, which leads to new investor money coming in, which leads to hedge funds having the ability to buy more bonds from companies.

It used to be that bond buyers were almost all unlevered. PIMCO still may be a major force, but hedge funds are making up more and more of the market, and they are definitely levered: they borrow money (from you guessed it, brokers) to buy the bonds.

The process described acts as an annuity for the hedge funds: the bonds increase in value over time as new money comes in and bids up prices. This process continues until either supply increases by too much or demand drops because new money stops coming in. The brokers act as gatekeeper to this process. There is nothing they can do about a drop in new money coming in, but they know that if they control supply properly (by advising companies on price and what the market can bear) and thereby keep the process "in the money", investors will tend to keep chasing returns and the money will flow.

We think the convertible bond market is stretched right now and are betting on a pull back in what we consider a very homogeneous market: individual bond prices move more as a result of overall supply and demand of the market than because of their own circumstances. In other words, based on the amount of new issues, the brokers are being a little aggressive here.

This is a small warning for what I see as a larger concern. Because hedge funds buy bonds on leverage they are inherently very sensitive to credit concerns: small changes in credit assumptions can have a large impact on the value of their positions. This has led them to seek credit protection. This has led to the growth of a new derivatives market and many new products based on one major one: credit default swaps.

I have described credit default swaps before and this market is not that new. I comment on it now because its growth over the last year, as in previous years, is nothing short of phenomenal. We estimate that the notional value of credit default swaps has grown around 50% in the last year.

Credit derivatives introduce a source of short gamma, which is as I have described in of itself like leverage: it is a contingent liability.

Financial risk is increased through leverage and decreased through de-leverage. It cannot be reduced in any other way, but it can be "defeased" or passed on to more and different participants. The key to all of this is who is bearing the ultimate risk. If levered participants are bearing the ultimate risk, the situation is inherently unstable; if unlevered participants are bearing the ultimate risk, the situation is not. This is what I am trying to assess now. It is like controlled growth versus uncontrolled growth.

Given the level of growth, I am leaning toward unstable.

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No positions in stocks mentioned.

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