And now for capital structure arbitrage
Antony Currie and
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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.
But you could put a partial hedge on a bet on the bonds by shorting
the stock. That’s exactly what Boaz Weinstein, head of credit
derivatives trading for the Americas at Deutsche Bank, did. He’s one
of a growing number of bank proprietary traders and hedge fund
investors who see profits to be made by trading across asset classes
to benefit from big discrepancies between the debt and equity prices
of the same issuer.
A bold new arb play
According to traders at several investment banks, capital