NEW YORK ( TheStreet) - Hedge funds BlueMountain Capital Management and Daniel Loeb's Third Point are jumping into embattled oil and gas driller Chesapeake Energy (CHK - Get Report) by way of convertible bonds, and this time they think the trade won't blow up in their face.
In contrast to convertible bond arbitrage plays that netted hedge funds billions in losses in 2005 when General Motors (GM - Get Report) and auto parts supplier Visteon (VC) faced takeover speculation and tender offers from the likes of investors such as Kirk Kerkorian, a change of wording makes BlueMountain and Third Point poised to benefit from any deal activity.
That's because while a takeover - called a "change of control event" - used to blowup convertible arbitrage strategies, a new standard to convert bond holdings into stock after an acquisition signals that both BlueMountain and Third Point could see a large gain from their bets, were Chesapeake to be acquired.
In 2005, a Deutsche Bank analysis calculated that takeover speculation netted hedge funds $32 billion in losses tied to backfired convertible bond arbitrage strategies because the gains on long bond bets were muted from M&A, while short stock investments plummeted.After a subsequent change in the language surrounding convertible issuance, a UBS Asset Management white paper highlights that new provisions now compensate convertible bond holders for takeovers by giving investors a put right (often at par) if an acquisition takes place. The new feature "offers protection against the possibility of an acquirer with a substantially worse credit quality," added UBS in the white paper. Amid a flurry of asst sales from Chesapeake Energy and speculation that its shale oil and gas assets would fit nicely in the larger exploration portfolios of super majors like ExxonMobil (XOM - Get Report) or Chinese drillers, BlueMountain and Third Point's convertible bond bets stand out as an interesting development for the Oklahoma City-based company, after it settled an activist push and board overhaul launched by leading shareholders Southeastern Asset Management and Carl Icahn in June. In second quarter holdings released on Tuesday, Third Point and BlueMountain disclosed they bought Chesapeake Energy convertible bonds worth $5 million and $6 million, respectively, for an approximate 20% discount to their face value, according to 13F filings with the Securities and Exchange Commission. In the bonds, BlueMountain has the right to convert every $1,000 of its $6 million in principal for 19.38 shares at a conversion price of $51.58, while Third Point can convert every $1,000 of its $5 million in principal for 11.65 shares at a conversion price of $85.81. The filings also show Chesapeake bonds were Third Point and BlueMountain's only convertible bets within large portfolios of stocks and options highlighted by investments in Yahoo! (YHOO) and News Corp (NWSA), respectively.