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Credit arbitrage: Probe firms proffer arb profits to hedge funds

Investigations into the backdating of stock options has caused around half of the more than 100 companies under scrutiny by the SEC and/or the Department of Justice to miss deadlines for filing earnings. More are likely to follow, says Todd Fernandez, senior analyst at independent institutional research firm Glass Lewis & Co.

It is alleged that the date of options granted to executives was manipulated so that they appeared to have been granted at an earlier date when the price was more favourable. As a result, corporates have delayed filing their earnings in order to remain compliant with the Sarbanes Oxley Act of 2002, which requires executives to attest personally to the accuracy of these statements.

The delay in providing this information to bondholders has caused many of these companies to technically breach their bond covenants. Hedge funds are having a field day.

Technical breach

Rating agencies such as Standard & Poor’s are not overly concerned about whether or not there is a breach of covenant in these cases as it considers them to be technical defaults, where the company is likely to meet the requirements in a timely fashion. Hedge funds, however, have been quick to take advantage of any such technical breach.

A breach enables bondholders either to negotiate a fee to allow the waiver of the covenant or force the company to repay the debt at par. For example, if the bondholder had bought the bonds at 80 cents he could now demand a $1, or par, repayment.

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