Convertible bond decline could impact credit derivatives

Falling valuations in the European convertible bond market during the last few months could lead to a decline in credit default swap values, as convertible investors seek to unwind their hedged positions.

Convertible volatility has followed the general decline in volatility across asset classes since the turn of the year, said a report by US investment bank Merrill Lynch.

According to figures released by UBS Warburg, the Swizerland-headquartered investment bank, convertible issuance has declined 66% in Europe since the start of the year. But major hedge funds, which typically make up the largest convertible investors, are still buying convertibles and waiting for volatility to pick up.

This is not the case for smaller hedge funds and other investors that entered the market last year. Merrill said many of these are re-examining their portfolios and looking to exit the market due to scarce returns.

Convertible investors often unlock cheap equity volatility by hedging out credit risk through the purchase of credit default swaps or the sale of callable asset swaps. “Hedging flows from convertible arbitrage funds can be an extremely powerful influence on credit derivatives levels and the default swap basis,” said the Merrill report.

Contracting spreads in the convertible market could lead to investors unwinding their hedged positions, resulting in a tightening of default swap spreads.