And now for capital structure arbitrage
Markets have crushed banks this year but now some see a profit to be made in arbitraging debt against equity. It's a smart trick. Turning it into a sustainable business will be even smarter.
Household is about to default on its bonds. Or at least that's what might be inferred by looking at its spreads towards the end of October. The US consumer finance company's benchmark 10-year bonds, launched last year at a spread of 155 basis points over US treasuries, had hit 800bp over. Default swap prices were even wider at 900bp over. Yet Household still had its single-A rating and its equity price, though way down on its high of $63.25 in April 2002, was still trading steadily at between $22 and $28. Was this really a company about to go bust, or one suffering from the fear and loathing of big debt issuers that has gripped credit investors for much of this year?
It sounds like the perfect opportunity for taking a bet on the company's future by loading up on its bonds at those juicy wide spreads. But wait - what if Household's bond investors had correctly sensed it was on the point of meltdown and it was the equity investors who were over-optimistic about the company? You would not be able to hedge that long bond position when the default swap was at even wider levels than the bonds.