Winds of change

correlation

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The Standard & Poor’s downgrade of General Motors Corp. and Ford Motor Co.—although well-broadcast to the market—managed to push cash bond spreads out by as much as 140 basis points on the day of the rating action. But the damage wasn’t specific to just real-money investors, and traders involved in complicated credit-default swap (CDS) transactions and collateralized debt obligations (CDOs) felt much of the pain.

And even though a good share of this havoc was localized within credit hedge funds and the Wall Street dealers, this downturn could herald a paradigm shift in the way CDOs have been driving the cash bond market and could force investors to rethink the dynamic relationships that have existed between the two interrelated markets.

“The CDO market acted as a stabilizer in 2004 but clearly it has now gone onto the flip-side, acting as a driver of volatility, and will drive volatility in the next few months or so,” says Robert McAdie, global head of credit strategy at Barclays Capital in London.

The repricing of correlation

The source of the problem was in a popular trade made by many dealers and credit hedge funds. The trade—a mezzanine hedged equity strategy in the CDX and iTraxx indices—assumed that correlation would remain constant, and when it didn’t, investors lost a lot of money.

The hedge funds and dealers would assume risk in the equity tranche, and hedge that position by going short on the mezzanine tranches. According to a research note by Banc of America Securities, investors will typically hedge using tranches to increase carry, rather than hedge with the index. “The investor adds premium by hedging with a leveraged product, in exchange for the risk that the market may perform differently from model expectations,” the report says.

Idiosyncratic events in the market, namely the spread widening in the auto sector and trepidations caused by LBO risk, turned this trade on its head. The equity tranche sold off while the mezzanine tranches rallied, leaving investors who were long equity hedged with the mezzanine tranches on the losing end of both trades.

While this particular trade does offer investors some protection against a general widening in spreads, it does not protect against an increase in idiosyncratic risk, says Kevin Murphy, portfolio manager at Putnam Investments in Boston, which has around $70 billion in fixed-income assets under management.

“Equity sold off a lot more than the senior tranches, and when [investors] went to unwind their positions they exacerbated the problem,” says Murphy.

The effects were striking. Banc of America notes that since the beginning of April, “an investor who sold equity tranche protection and delta-hedged with the index would have lost about $500,000 per $10 million tranche notional. Assuming a 10% initial margin requirement, this gives a return on equity (ROE) of about –50%. These very significant losses were magnified for investors who hedged with the mezzanine: despite higher carry, these investors lost about $1.4 million per $10 million tranche notional, for an ROE of about –90%.”

But some hope that, as volatility has increased so dramatically in the market, some new players will come in and take up the old positions, stemming the dramatic losses. “There are the beginnings of interest from distressed hedge funds due to the extreme equity tranche volatility,” says Matt King, head of quantitative credit strategy at Citigroup in London. “There is some chance of new people entering the market, as some hedge funds have not dabbled yet. But there is little incentive to do so at the moment and the feeling is that there will be further corrections and so better entry levels.”

An underlying problem that exists as the correlation products reprice is that credit hedge funds haven’t been posting significant returns this year. According to the Banc of America report, in March, credit hedge funds lost an average of 1%–3% and another 1%–2% in April. “That scenario suggests the potential for forced selling from hedge funds whose investors have a shorter-term horizon and, consequently, a significantly broader market impact,” the research note says. “If that occurs, there is a risk of spread widening in CDS and the indices even as overall credit risk trends lower.”

Citigroup’s King says, “[Credit hedge funds] had a good year up until March and may have redemptions coming up. But since the lockout period is between one and three months, they will take time to filter through,” he says. “Convertible funds are much larger and have had poor performance since early 2004. Some reports suggest they are suffering redemptions of 15%–20% year-to-date—net selling of $30 billion to $40 billion out of the total $290 billion market.”

The CDO driver

A Barclays report notes that “the CDO bid is now structurally altered, as hedge funds will no longer be the conduit to offset dealer risk. The cash market can no longer rely on the CDO bid as a driver of spread tightening in the future.” Barclay’s McAdie further pointed out that “there is a reassessment of risk in the CDO market. Structured hedge funds will reduce the overall risk tolerance in the space.”

For the past year, CDO issuance has been a major driver of spreads in the cash bond market. When banks issue synthetic CDOs, they buy protection via the CDS market, which their credit-derivative or correlation desks then hedge by buying cash bonds or selling protection on. Synthetic CDOs can have significant leverage, so trading desks can suddenly come into the market with hundreds of millions of dollars in corporate risk on which they want to sell protection. Furthermore, the hedging of synthetic CDOs tends to take place quickly, putting intense pressure on the market.

But now, some speculate that since correlation pricing models failed investors so dramatically last month, this could cause activity in the CDO space to wane, as structured credit professionals rethink the risk associated with these types of securities.

“I don’t believe that what you’ve just seen is a reversal of the strong technicals that support the market,” says Putnam’s Murphy. “The strong tailwind that we had due to the CDO market is not there. It hasn’t turned into a headwind, but the tailwind is gone.”

Additional reporting by Hardeep Dhillon

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