Credit hedge funds and proprietary trading desks are starting to encroach on the trades once reserved for the distressed, equity long/short and merger arbitrage funds. US airline companies have been in trouble for several years now, most recently because of the overwhelming costs of their defined-benefit pension plans. This year, for the first time, credit-specialist hedge funds have been taking a variety of trading positions as a result. Even before the pension problems, credit hedge funds were taking various positions on airlines this year, such as putting on long/short trades on an airline’s secured and unsecured paper.
They have also been active traders in media and telecom securities, especially as various companies in these sectors turn up as leveraged buy-out and merger candidates.
Making bets on LBOs
It’s the latest form of capital structure arbitrage, a strategy that became particularly popular in 2002 and 2003. Back then the rout in both the debt and equity markets had caused so much spread widening and dislocation between debt and equity prices that there were, relatively speaking, easier trades to put on during the 15 months or so that spreads tightened.
It has been tougher to find those this year. A lot of funds thought they had found one at the start of the year, explains Harold Yoon, who runs ING Investment Management’s fund of funds business in New York. “At the end of last year many credit funds decided that junior debt had come in too much relative to senior debt, so went short the junior and long the senior debt, waiting for what they saw as more rational relative pricing to return. It hasn’t yet, and many have been hurt by those positions.”
The leveraged buy-out and merger plays have thus become more enticing. “Over the past three years corporates have hunkered down, reduced capital expenditure, restored their balance sheets and are now generally flush with cash,” says Boaz Weinstein, head of integrated credit trading for Deutsche Bank in New York and a big proponent of capital structure arbitrage since 2001. “That’s fostered a fairly low volatility benign environment as far as hedge funds are concerned as it doesn’t leave much room for arbitrage. So instead traders have started looking for companies in special situations such as LBOs or payers of large one-time dividends.”
Real money accounts might try to avoid such names, but hedge funds, says Weinstein, “will draw up lists of investment-grade candidates, short the bonds and buy the stock. Citizens Communications is a good example. There were rumours earlier in the year that it would be bought, and then that it might be an LBO candidate. Its bonds could widen or tighten 200 basis points.”
This is hardly the model-based approach to capital structure arbitrage that was being touted two years ago. “It’s certainly become more of an art than a science this year,” says Weinstein, though he also adds that “these are one-off trades, and only in a couple of sectors, such as telecoms”. The media sector is another.
Another idea that seems to be picking up, explains Jim Ballentine, global head of structured credit at Lehman Brothers, is the contingent trade. “It involves putting on credit trades contingent on interest rate risk or forex risk,” he says. “It makes sense if you have that kind of risk on your books. Valuation is pretty complicated, though, and there’s not much liquidity yet, so you need to leave some wriggle room to risk manage it. So we have been offering portfolios of contingent risk, with, say, 10 trades packaged up. Some hedge funds have got involved that want to pick up some credits on the cheap and are willing to put 5% or 10% of their exposure to these credits into one of these.”
Andrew Feldstein, portfolio manager at Blue Mountain Credit Alternatives, has looked at the idea, which he calls quanto trading. “It allows investors to take a view on the correlation of default risk and the level of interest-rate, forex or commodity risk. It’s hard to price because of all the variables, but there’s a real market need for it.” As yet, his firm has not done any trades.
Credit arbitrage strategies are having a big effect on the credit market as a whole. “The hedge funds are pushing the envelope, making illiquid products more liquid,” says Kehong Wen, managing director at KMV. “There will always be hedge funds willing to invest or trade and get returns from providing liquidity.”
