COLUMN-No endless summer for convertibles: Peter Thal Larsen

-- Peter Thal Larsen is a Reuters columnist. The opinions expressed are his own --

By Peter Thal Larsen

LONDON, July 15 (Reuters) - Summer is typically the best time to buy a convertible. Car sales may be struggling, but convertible bonds are proving popular.

British Airways (BAY.L) is the latest big company to consider the instruments as a way of repairing its balance sheet. For related news click [nLE380967].

For investors, however, the biggest profits may be in the past.

Issuing a convertible allows companies to avoid equity offerings, which can be costly and cumbersome. Because they include an option on rising share prices, convertibles also tend to carry a lower interest rate coupon than senior debt, making them particularly attractive for companies that are currently strapped for cash.

Companies are tapping into resurgent demand from investors. Just nine months ago, this was hard to imagine. As turmoil hit the financial markets, hedge funds were being forced to dump their holdings of convertibles at distressed prices in order to meet margin calls from investment banks and redemptions from investors.

Since then, however, convertibles have enjoyed a rally. The Merrill Lynch Europe Convertible bond index is up more than 35 percent from its low point last October. Convertible arbitrage, meanwhile, is the best-performing hedge fund strategy so far this year, with the average fund returning 19 per cent in dollar terms, according to Credit Suisse/Tremont.

Most of these profits were made buying bombed-out issues in the secondary market. In recent months, however, investors have also gulped down new bonds. Globally, $36.7 billion was raised by issuing convertibles in the first half: double the issuance for the second half of 2008, though still well below the record $101 billion raised in the first six months of last year.

The rebound in demand masks a big shift in the way investors are now approaching the market. During the last downturn, between 2001 and 2003, the biggest buyers of convertibles were arbitrage funds, which hedged their exposure by shorting the stock of the underlying company and buying protection against a default.

The result was a more-or-less pure play on market volatility. By leveraging up, hedge funds were able to generate healthy returns -- for a time.

That kind of leverage is no longer available. The market is currently deemed sufficiently attractive to entice long-only investors, who account for about 50 percent of buyers of recent issues, according to bankers. Interestingly, some hedge funds are leaving part of their exposure unhedged, effectively using convertibles to make directional bets on the market.

In the long run, this approach is probably more sustainable. But it is also likely to be less lucrative. Over the past nine months, convertible investors have reaped outsize profits by taking advantage of a one-off rupture in the market. They should not be counting on a repeat performance. For previous columns, Reuters customers can click on [LARSEN/] (Editing by Martin Langfield)