Dented Convertibles, Too Cheap to Ignore

Another area of the market that has been hard hit by troubles in the hedge fund industry is the market for convertible securities. Convertible preferred stocks and bonds were heavily owned by the hedge fund industry. Some analysts estimate that as much as 70% of outstanding convert issues were owned by hedge funds.

Most of these funds practiced convert arbitrage, buying the bonds and selling short the underlying common stock. A falling stock market has damaged the value of these securities. The decline in value was exacerbated by the forced reduction of leverage. Many funds had leveraged up to increase returns, and when prime brokers demanded that they reduce leverage or pay higher borrowing costs, the selling pushed convertible market prices down more than 35% year to date. According to hedge fund industry analysts, hedge funds that specialize in convertibles are down more than 50% year to date.

Nick Calamos at Calamos Securities, a leader in the convertible bond markets, recently wrote a report to shareholders outlining exactly how cheap these markets are, in his firm's opinion. According to Mr. Calamos, the price of the average convertible issue is now undervalued by more than 10%. That is the steepest reading in more than 30 years, according to the report.

He also points out that during previous periods of relative undervaluation, the returns for the following two years were very strong for convertible investors. Earlier this week on RealMoney.com, Howard Simons wrote a great article on why he believes the asset class is severely undervalued and worth investigating as well.

I wrote a couple of weeks about some of the convertible issues I saw that looked interesting. For the most part, those names have a long way to go before the equity factor kicks in, but they have high yields, and the underlying companies have a good chance of surviving the current market and paying the dividends.

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At the time of publication, Melvin had no positions in securities mentioned, although positions may change at any time.

Tim Melvin is a writer from Stevensville, Maryland, who spent 20 years a stockbroker, the last 15 as a Vice President of Investments with a regional firm in the Mid Atlantic area. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Melvin appreciates your feedback; click here to send him an email.