Precarious Convertibles

One of the most ravished types of securities in the past six months has been convertible bonds—hybrid securities that are part stock option, part bond. They’re issued by companies as interest-paying bonds, and the holder has the option to convert into stock at a certain predetermined price, called a “strike price.”

The hedge fund industry has spawned more than 150 convertible bond funds, and one of the top performing among these is at Waterstone Capital Management, a Plymouth-based investment firm, which manages approximately $900 million. Shawn Bergerson, Waterstone’s founder and chief investment officer, has racked up an enviable track record at a particularly tough time in the market.

How have you been able to avoid the huge downdraft that we’ve had in the past three or four months in the convertible bond market?

Bergerson: We work really hard on credit selection, credit research, and valuation. That allowed us to avoid the big credit blowups in the second half of 2008. We shorted [or sold short, a bet that the price of a security will decline] and made some money on some short credit positions. Historically, we’ve always been net long [owning the security rather than shorting it], and we were net long credit last year. But a lot of the names we bought made money, and all the names we shorted from a credit perspective made money.

Secondly, we’ve viewed the entire credit market as an accident waiting to happen. We’ve thought this for the last couple of years, so when it started to unravel back in July of 2007, we quickly reduced our credit exposure and sold off any name that we didn’t have complete confidence in.

Did you focus on any particular types of bonds?

Bergerson: Yes, we stuck with the bigger, more liquid issues on higher quality companies. We felt like we weren’t paid to take the risk on other smaller issues, such as private placements, smaller deals, smaller companies, lower quality credits—especially in light of the market’s undisciplined behavior in 2006 and 2007.

Weren’t those the names that were also sold when the market was looking for any liquidity it could find?

Bergerson: Yes, that’s true. We also anticipated that in early 2008, when we felt the environment in convertible securities was really getting precarious. When people look at convertible securities, they usually look at them relative to a fair value assessment. To evaluate convertibles, you assign an appropriate credit spread [an interest rate differential relative to U.S. Treasury bonds of the same maturity], an expected volatility for the underlying stock, plus a few other things. But the credit spread and the volatility on the stock are the most important. From this, you can determine a fair value.