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Wednesday July 21, 04:32
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Hedge funds fill a strategy gap
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Hedge funds, faced with weak returns or losses on some of their strategies, have been flocking to a new one called capital structure arbitrage, which exploits mispricings between a company’s equity and debt, according to Financial Times.
"Cap arb" burst on to the scene two years ago when there were plenty of tele- communications companies and other former high fliers whose equity collapsed while their bonds were slower to reflect the impact.
"The fortunes of the two became interlinked in a downward spiral," says Viswas Raghavan, co-head of equity capital markets at JP Morgan.
The trick was to catch the arbitrage profits before the companies became "fallen angels" and their credit rating was downgraded to junk.
Several factors have since conspired to make the technique more popular.
One is that it is getting much easier to do, thanks to the rapid growth of credit default swaps (CDSs). These are a form of credit derivative that provides insurance against default.
With them, funds can readily go short in corporate bonds [selling in expectation of a price fall] in a way that would previously have been prohibitively expensive. Growing liquidity in the CDS market is making pricing tighter, allowing for greater use.
Another reason cap arb is growing is that other strategies such as convertible bond arbitrage, which require similar technical skills, are in the doldrums.
Sanjay Tikku, head of investment strategies for Europe and Asia at Tremont Capital Management, says: "May and June were awful."
Nick Cavalla at Man Global Strategies says: "A number of more traditional convertible bond managers, faced with no real tail-winds, have attempted to reinvent themselves as cap arb."
Mr Tikku says: "It’s no surprise that managers have shifted their attention to relative-value trades such as capital structure arb. Convertibles are hybrid debt-equity instruments, so a convertible arbitrage manager’s skill-set has to span these two parts of a firm’s capital structure."
Not only are convertible bonds down, so too is the whole of corporate credit as a hedge fund play. While betting on the direction of credit spreads has had a good two-year run, it is no longer working because credit spreads have tightened too much for the risk-reward trade-off to be favourable.
During May and June, capital structure arbitrage was one of the few hedge fund techniques in positive territory, according to Tareen Hussain, credit salesman at BNP Paribas. However, there are no independent figures because databases such as CSFB/Tass Tremont do not at present show it as a separate category.
One thing arb funds do is compare movements of the equity and the bond spread. If the level of correlation between the two as reflected in the market is different to the correlation predicted by their model, the trade should make money, assuming that the model’s reasoning is accepted by the market.
While the fallen angels era is over, other opportunities have presented themselves. Growth of dividend payouts has made certain trades viable which would not have been previously.
A "wings trade" involves borrowing stock with a good dividend yield and purchasing the associated CDS, on the assumption that creditworthiness is going to deteriorate. As dividend payouts have been increasing, a long position in equity acquired through stock borrowing can sometimes finance itself.
If the credit does deteriorate, the core of the profit will accrue from the increasing value of the CDS.
Nokia, with its chunky dividends, has been one stock on the hedge funds’ shopping lists.
Other opportunities appear in specific situations such as legal battles. Tobacco company BAT, facing uncertainty over litigation claims, has seen its share price fall but its credit, as expressed by the spread on its credit default swaps, has not changed.
This year’s modest pick-up in merger and restructuring activity has also provided more scope for capital structure trades.
However, fund managers switching from convertible bond arbitrage will not be getting the almost risk-free profits that some convertible issues offered last year. They will mostly be betting on a price movement turning out the way they expected.
"Cap arb does require a directional view," says Mr Cavalla.
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