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July 31, 2000

Hedge Funds Ride With Convertibles

By Laura Santini üInvestment Dealers' Digest

Hedge funds account for an ever-increasing portion of trading business for Wall Street's biggest firms.

But while equity desks - and especially their customers - may abhor the hedge funds for their flipping and short-selling, the convertibles desks love them. Hedge funds are considered an important source of liquidity not only by Street convertible traders, but also by their traditional pension fund and mutual fund customers.

"The relationship is very affable between hedge funds and sell-side firms," said Steve Barral, who heads the convertibles desk at J.P. Morgan. In recent years, the hedge fund community has come to dominate convertibles, particularly in today's volatile market environment. This year, hedge funds probably account for 70 percent of secondary trading on a typical firm's convertibles desk, Barral said. Six years ago, hedge funds probably accounted for only 30 percent of that total, he said.

Primary Market

In the primary market, hedge funds' presence has also grown, now representing about half of all commissions, Barral estimated. The big growth came during the past year or so, as a slew of hedge funds has been launched that invest solely in convertibles. These days, hedge funds are critical to liquidity. For example, when a firm prepares to bring a new issue to market, capital markets pros will emphasize the issue's attraction for the hedge funds when they pitch it to fund managers.

As the head of convertibles trading at another Wall Street firm described it, the pension fund and mutual fund manager will ask outright, "What do the hedge funds think of it?" Convertibles are right down the hedge funds' alley. Bear Stearns' convertibles analyst Debrah Yaw said that's because hedge funds, expert at arbitraging, seek to make money from differences in the price of the convertible bond and the price of the equity. So if the hedge funds are willing to snap up a new issue of convertible bonds, the bond's valuation must be attractive, he explained.

"The convertibles business has evolved to where the majority of trades take place in relationship to the stock price," concurred Mike Boyd, hedge fund manager at Forest Investment Management. He agreed that hedge funds sway other institutions when a firm is preparing a new issue. "[Appeal with hedge funds] indicates what supposedly sophisticated investors are doing."

Another way hedge funds provide liquidity to other institutions is by taking over the institutions' convertible bond positions when the underlying stock price begins to rise. In such instances, the convertible bond begins to track the performance of the stock, making the security less appealing to institutions that prefer to own the stock outright rather than the bond.

Because hedge funds profit from the volatility in the price difference between the bond and the stock, they are more willing to buy these securities from the institutions. But on equity trading desks, hedge funds' reputation for flipping and shorting has kept firms from admitting to their clients that hedge funds will participate in an IPO. On the other hand, there's a code term traders use when hedge funds aren't involved. "When traders say a deal is well-placed,' that means it is in the institutions' hands, not hedge funds'," one equity trader said.