Friday, September 26, 2008
Short-Sale Ban Wallops Convertible-Bond Market - WSJ
The Securities and Exchange Commission's ban on short selling of financial stocks has effectively shut down much of the convertible-bond market, a crucial area of financing for struggling companies. Convertible securities are essentially bonds that can be exchanged for stock in the future. It's a relatively small market with less than $400 billion in securities outstanding, according to market participants, a fraction of the total for investment-grade bonds. But in times of stress, struggling companies turn to convertibles in order to raise capital when a share price has fallen. Battered financial companies, such as Bank of America Corp. and Citigroup Inc., sold billions of dollars in convertible debt earlier this year. Of the roughly $60 billion in convertible securities issued in the first eight months of this year, 65% was from financials, according to research by analysts now at Barclays Capital. "At the beginning of the year it was the 'convert' guys that provided the liquidity to all these institutions. Now the SEC is literally shutting the market down," says Adam Stern, chief executive at hedge-fund manager AM Investment Partners. A major buyer of convertible securities has long been hedge funds employing a strategy known as convertible arbitrage, which aims to profit from mismatches between the price of a company's convertibles and its stock. At its most basic level, the strategy entails buying the convertible and selling the underlying stock short. In convertible arbitrage, short selling -- the sale of borrowed stock -- is not a bet against a particular company's fortunes, but rather an actively managed hedge. The combination of long and short positions is essentially neutral to moves in the underlying stock but will profit from the stock's volatility. The SEC rule banning short sales of financial stocks makes that arbitrage impossible. While most nonfinancial stocks still can be shorted, the effect of the ban is rippling through the entire convertibles market, according to traders and money managers. The anti-shorting rules are scheduled to expire on Oct. 2, but an extension is widely expected. "At least 75% of investors" in convertible securities hedge their positions, Elliot Bossen, chief investment officer of Chapel Hill, N.C., Silverback Asset Management, wrote in a letter to the SEC and lawmakers Wednesday. "This important source of capital will disappear entirely," if the rules remain in effect, he wrote, adding that the SEC's move "contributed to the seizing up of liquidity in the market for convertible securities." Traders say the impact has been clearly visible in the prices of convertible securities. Typically, when a stock falls, converts fall about one-third as far the common shares. Instead, convertibles on financial names have been suffering big losses compared with the stocks. According to traders, the convertible preferred securities issued by Bank of America as part of a $6.9 billion capital raise in January have fallen about 9% in value since last Friday, while the bank's stock is down about 6%. Citi's convertible preferreds, also issued in January, are down about 10% while the stock is down 3%. Because of the short-sale rules, "you've got people who are being forced to sell," says mutual-fund manager Edward Silverstein, who oversees the MainStay Convertible Fund. Market participants say there are many reasons trading in convertibles has dried up. Not only does the SEC rule hamper hedge funds, Wall Street trading desks also have been handcuffed. At some firms, convertible securities are traded separately from stocks. While an exemption provided by the SEC allows dealers to sell stocks short as part of their function as market makers, that leeway doesn't apply to market-making in convertibles. Participants in the convertible bond market say the SEC should follow the example set by regulators in the U.K., whose short-selling limitations allow for hedging. An SEC spokesman declined to comment specifically on convertibles, but said it may consider additional steps "as necessary."