The downgrade of General Motors (GM) and Ford to junk status by Standard & Poor's in early May has shaken up the structured credit market. The market is abuzz with stories of hedge fund losses on correlation trades, prompting one high-profile fund – US-based Highbridge Capital – to write to investors denying that it had exposure to these trades. Rumours of substantial losses also affected investment banks, with share prices of some (particularly those with stakes in hedge funds) sinking in the week following the downgrades.
It would seem that the apocalypse scenarios being played out in some parts of the media over the past few weeks are overdone, but there's no doubt that a number of players are hurting. One of the most popular strategies in the structured credit market has been to go long the equity and short the mezzanine tranches, with hedge fund managers attracted by the positive carry and convexity this trade provided. That strategy works if credit spreads move in tandem, with the investor delta hedged against any overall widening in market spreads. However, the strategy is at risk if just one or two names default or widen significantly.
With the downgrade of GM and Ford, the 0–3% tranche correlation in the iTraxx and CDX indexes dropped significantly, creating losses for long-equity positions. At the same time, the mezzanine tranches have strongly outperformed, leaving some funds with nasty mark-to-market losses, estimated at 15–30%.
The market has moved to such an extent that some analysts reckon now is a good time to short the mezzanine tranche. The problem is that the dealer community is also long equity/short mezzanine through the strong demand for mezzanine tranches from real money accounts. That means hedge funds and dealers are pretty much the same way – needing to cover their short mezzanine positions. For their part, many of the real money accounts are buy-and-hold investors, and while some may be tempted to book profits, many may want to hold on to their positions.
So, pain for some hedge funds, yes. The credit market will probably be congested and illiquid until hedge funds can unwind their positions. But will this a cause a contagion effect across the credit markets, the collapse of some hedge funds that are long credit, as well as a mass redemption across all hedge fund strategies, as has been suggested by some commentators? It would seem unlikely. More probable, the market will slowly get back to normal as new investors, tempted by attractiveness of short mezzanine trades, gradually enter the market.
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Nick Sawyer, Editor