June 11 (Bloomberg) -- Convertible bonds that punished hedge funds in 2008 are driving returns at Canyon Partners and Citadel Investment Group LLC and helping companies from JetBlue Airways Corp. to Alliance Data Systems Corp. raise capital.

Canyon, the $14.4 billion investment firm run by former Drexel Burnham Lambert Inc. bankers, gained more than 51 percent in its convertible fund through May 22, according to a May 29 letter sent to investors. Citadel posted a 21 percent return in its two main funds through May, aided by convertible bets.

Debt markets have advanced in 2009 after President Barack Obama and Federal Reserve Chairman Ben S. Bernanke committed $12.8 trillion to ease credit. Convertible securities climbed 20 percent after tumbling 27 percent in the last four months of 2008, according to Merrill Lynch & Co. index data. That’s fueled a 25 percent rise for convertible-bond hedge funds, the most among all strategies tracked by Hedge Fund Research Inc.

“Converts were extremely distressed, extremely good value at the beginning of the year with prices low due to forced selling from funds as opposed to rational valuation,” Shawn Bergerson, chief executive officer of Minneapolis-based Waterstone Capital Management LP. “They’re still cheap by historical standards.”

Bergerson’s $815 million convertible hedge fund returned 25 percent this year through the end of May after rising 12 percent in 2008.

Short Selling

Convertibles allow investors to exchange bonds for stock when shares of the issuers reach preset levels. Hedge funds typically invest in convertible bonds and then sell short the stock, seeking to profit from price differences between the two securities. Shorting involves selling a security an investor doesn’t own and has borrowed in anticipation of making a profit when the price falls.

Hedge funds that trade convertible bonds lost an average of 34 percent last year, making them the worst performers among 14 strategies tracked by Chicago-based Hedge Fund Research.

Chicago-based Citadel, the $11 billion investment firm founded by Ken Griffin, lost 55 percent in its two main funds, in part due to a wrong-way bet on convertibles. Canyon Capital Arbitrage Fund LP lost 36 percent. Executives at the funds declined to comment.

The strategy failed in 2008 when hedge funds had to sell the securities in a declining market to reduce borrowing and meet investors’ demands to get back their capital.

The funds also couldn’t hedge their positions after the government banned short selling of financial stocks following the collapse of Lehman Brothers Holdings Inc. in September.

Canyon’s Bets

Canyon made money earlier this year betting that the difference, or spread, between convertible bonds and corporate bonds or credit-default swaps would narrow, according to the May 29 letter from the Los Angeles-based firm. Credit-default swaps pay the buyer value if a borrower defaults in exchange for the underlying securities or cash equivalent.

The average gap between investment-grade corporate bond yield spreads and credit swaps narrowed from 2.74 percentage points in November to 1.23 percentage points as of May 28, according to Citigroup Inc.

The fund also gained when companies including AmeriCredit Corp. and Chesapeake Energy Corp., the Oklahoma City-based natural-gas producer, bought back their convertible bonds or exchanged them for stock as the prices fell.

AmeriCredit, a lender to car buyers with blemished credit records, bought $21.1 million since the end of March at 55.6 cents on the dollar, according to a May 11 regulatory filing from the Fort Worth, Texas-based company.

Change in Strategy

Canyon owned a large percentage of distressed and high- yield convertible bonds that were trading at less than 50 cents on the dollar. Convertible securities graded junk, or below Baa3 by Moody’s Investors Service and BBB- by Standard & Poor’s, gained 12 percent in May, according to Barclays Capital.

As of April, Canyon had reduced its bets on narrowing spreads and high-yield convertibles and is now looking to buy new convertible bonds as they are issued.

“While we suffered along with the rest of the market in 2008, we were quick to reconstitute the portfolio to take advantage of the most stressed areas of the convertible market,” Canyon’s Joshua Friedman and Mitch Julis wrote in their May 29 letter. They met at Harvard University and worked for Michael Milken at Drexel in the 1980s.

Convertible-bond issuance fell to zero in the fourth quarter of 2008, Canyon said in the letter. Twenty issuers raised $7.7 billion this year through the end of April, Canyon said, citing data from Barclays Capital.

JetBlue Debt

JetBlue, the New York-based carrier partly owned by Germany’s Deutsche Lufthansa AG, sold $175 million in convertible debt this month. The 6.75 percent notes, split between a $100 million offering and $75 million sale, are due in 2039 and can be converted into stock at $4.89 a share, the company said in a statement June 3. JetBlue fell 6 cents, or 1.4 percent, to $4.26 at 4 p.m. in Nasdaq Stock Market trading.

Alliance Data, a credit card-processor, raised $300 million of 4.75 percent convertibles to repay debt and buy back stock, the Dallas-based company said June 3. Alliance Data set a conversion price of $70.54 percent. The stock rose $1.11, or 2.3 percent, to $48.47.

“Many companies couldn’t raise capital for the second half of last year. The market wasn’t willing,” said Bergerson of Waterstone. Now that capital markets have eased, “they’re getting a shot in the arm.”

To contact the reporters on this story: Pierre Paulden in New York at ppaulden@bloomberg.net; Katherine Burton in New York at kburton@bloomberg.net

Last Updated: June 11, 2009 16:23 EDT