Friday, December 12, 2008

Cheap bonds make for easy money


The price difference between cash bonds and credit default swaps provides a good opportunity for investors with cash to spare.

When markets are put under extreme stress they create all kinds of oddities. Under normal circumstances, opportunistic traders at hedge funds and proprietary trading desks take advantage of such peculiarities and, in doing so, restore equilibrium. Today, markets are not so efficient.

One obvious manifestation of this is the discrepancy between corporate bond prices and the price of credit risk. Since the collapse of Lehman Brothers in mid-September, bond prices have fallen much more dramatically than the risk of default has risen, creating a yawning gap between the price of credit default swaps (CDS) and their underlying bonds.

This is a direct result of the market conditions – bond prices are being pushed down to abnormally low levels by investors who are under pressure to de-leverage and reduce the size of their balance sheets. And in many cases they are the same investors who would normally take advantage of the distortion this over-selling has created.

This price discrepancy is known as negative basis. It is not a new phenomenon; institutions have been profiting from it for a long time with a very simple technique. They buy the cheap bonds and then insure against the risk of default by buying the CDS. This removes the credit risk and lets the investor pick up the spread for free. And, in many cases, corporate bonds are now trading hundreds of basis points cheaper than their CDS.

But with so many institutions unable to take advantage, structurers are now coming up with ways for private banking clients to get in on the action. "The idea of buying a bond and hedging with CDS is something that institutions do but which is tough for private banking clients to do because most of them don't have access to the CDS market," says Olivier Destandau at Deutsche Bank. "We've repackaged negative basis from the corporate bond market into a product that can be distributed to investors who typically don't have access to this opportunity."

The Deutsche product is simply a note linked to a portfolio of these negative basis trades. The bank's structurers buy the names with the widest spreads and package them into a special-purpose vehicle, which then sells the negative basis notes to investors.

Typically, the notes are structured over three or five years and are intended to be held to maturity, paying a semi-annual coupon and returning the investor's entire principal at the end of the note's life.

The coupon investors earn depends on the timing and size of the trade. During the past three months portfolios have typically generated 100bp or so over Libor, but recently Destandau says that he has been able to create portfolios with a spread of more than 200bp.

Although it is intended to be held to maturity, investors can sell the note whenever they want. "If market conditions normalise what you're likely to see is more appetite for the cash bonds, so the basis against CDS will actually tighten and this arbitrage opportunity will disappear," says Destandau. In that case, the value of the note will go up. "And because we're providing daily liquidity, investors can then trade the note and get out of it when they find a better opportunity.”

Depending on the client, such notes can be structured with fixed or floating rates, and can be quantoed into local currencies or bought straight in euros or dollars. The notes can be called by the issuer after one year, and quarterly after that.

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