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Mandalay Syndrome Realized



Just a few days ago, I wrote a piece reflecting the possible negative repercussions of the reduction in the tax rate on dividends for the convertible bond market. I noted that the Mandalay Resort Group (MBG:NYSE) bonds went dramatically down in relative price as a result of the company's dividend announcement, and that this could spill over into the general market. This is occurring.

Convertible bond prices can go down because: a) interest rates in general go up, as a function of either government rates rising or corporate spreads widening, making the bond component worth less, or b) volatility decreasing, making the embedded call component worth less. In this case neither is happening. Instead, the convertible bond managers are now discounting the prices that they are willing to pay as a result of the increased risk that companies may increase their dividends. This is a structural event that decreases the value of the embedded call (by the present value of the increase in the dividends times the delta of the option) without a decrease in the volatility assumption.

The bottom line is that convertible bond prices in general are declining. Convertible bond hedge fund returns may suffer in the coming months.

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No positions in stocks mentioned.

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