Hedge Funds' Insider Trading in Convertible Bonds

How do hedge funds get their outsize returns? And why do so many hedge funds list "convertible arbitrage" as one of their main sources of profits? Could the answer to both questions be "insider dealing"?

French regulators have fined three hedge funds the maximum-allowable €1.5 million ($2 million) apiece for trading on inside information in advance of a big convertible bond issue from Vivendi Universal. Deutsche Bank got hit with a €750,000 fine, and a fourth hedge fund received a €1 million penalty. All told, the fines total more than $8 million.

To understand what happened here, one has to understand how convertible bonds work in reality. Convertibles are bonds which can convert into stock at a certain price at a certain point in the future. Investors get the certainty of bond coupon payments, plus an option to buy stock at a given price if the stock has risen. But in fact investors in convertible bonds are almost never simple buy-and-hold funds or individuals who like the structure. Instead, convertible bonds are bought overwhelmingly by hedge funds, who use them as part of a sophisticated relative-value play which invaribly involves shorting the underlying stock.

When an investment bank issues any securities, be they bonds or stocks or convertibles, it will sound out investors in advance to see how much they're willing to pay. But this practice is particularly problematic in the case of convertibles.

Let's say you're a hedge fund, and you get a phone call from Deutsche Bank asking how much you might pay for a Vivendi Universal convertible bond. You're more than happy to talk numbers with the guys on Deutsche's syndicate desk – and then, as soon as you put down the phone, you start shorting Vivendi shares like there's no tomorrow.

Because convertible bonds are always bought by investors who go short the underlying stock, share prices tend to fall when a convert is issued. So if you have advance notice that a convertible bond is coming, you can make money even without buying it at all, just by shorting the stock. More likely, you will buy the bond as well, when it's issued, but it's always better to short a stock at a higher price, before everybody knows about the convertible, than it is to short the stock at a lower price, when the convertible is issued.

The only problem is that you're trading on inside information, and that's illegal. As Bloomberg's Elisa Martinuzzi reports:

Underwriters typically speak with investors to gauge demand before selling securities. They are required by [French regulators] to tell buyers they can't trade on the information and they must store the dates and times of the conversations.

Of course, if buyers really felt that they couldn't trade on the the information, then they'd never agree to talk to the syndicate desk in the first place. There's no reason to tie your own hands without being paid somehow. But sometimes the insider trading is so large and so egregious that the regulators have no choice but to step in.

In the case of the Vivendi offering, the share price fell an eye-popping 14% in the three days before issue, so it's hardly surprising that the regulators investigated. Indeed, the most depressing thing here is that the convertible bond issue in question happened all the way back in 2002: it takes a long time for these cases to be investigated and prosecuted, and even this one is still ongoing, with the hedge funds appealing the decision.

So don't expect the market in convertible bonds to dry up any time soon. But do leave it to the professionals. They have much more information than you do. And I can assure you that they make much more than $2 million on their most successful trades, in any case: even after paying the fines, they're likely to come out ahead on this deal.

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