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Section: Daily Dispatches

The Sky Darkens for Bondholders

Backfiring Bets on Derivatives,
Corporate Executives' Allegiances
Are Among Worries Raising Risk

By Mark Whitehouse, Gregory Zuckerman,
Henny Sender, and Carrick Mollenkamp

The Wall Street Journal
Wednesday, May 11, 2005

The U.S. credit market is getting riskier.

As hedge funds book losses and the prices of corporate securities
and the derivatives based on them move in unusual ways, investors
are waking up to troubling questions. One is whether the hedge
funds, some of which have made big bets on complex trades involving
credit derivatives, could spark a larger contagion that would affect
all markets. Another is whether the risk of lending to corporate
America is worth the return, which until recently had been at
historical lows.

There are other clouds hanging over bondholders' heads, such as the
risk that executives, goaded by low stock prices, will take actions
that favor shareholders over bondholders. Or that private-equity
firms will continue to pile debt onto the companies they own.

"We are entering into an 'adult-swim-only' environment now for
corporate bonds," says Mark Kiesel, a portfolio manager at Pimco, an
asset-management firm based in Newport Beach, Calif.

Exhibit A: The recent downgrades of General Motors Corp. and Ford
Motor Co. have caused the prices of two different types of complex
credit derivatives -- credit-default swaps, or CDSs, and
collateralized-debt obligations, or CDOs -- to move in unexpected
ways, leading some major hedge-fund bets to go wrong. CDOs are pools
of corporate debt or certain swaps that have been repackaged into
slices, known as tranches, that carry varying levels of risk and pay
varying yields. CDSs are products that provide investors insurance
against corporate defaults.

One particularly painful pang of anxiety stems from losses in so-
called correlation trades, or trades that bet on certain debt
investments that often move more or less together in price.
Correlations have broken down in recent days, surprising hedge funds
and other sophisticated traders.

That is what happened in the case of the GM downgrade. Some
investors bought GM bonds but sold short, or bet against, the auto
maker's shares, figuring that moves in the two investments would
compensate for, or hedge, one another. But after Standard & Poor's
slashed GM's credit rating, the bonds did worse than the shares,
hurting these investors.

Even more correlation trades took place in other credit derivatives.
When GM was downgraded, the highest-risk slice of these investments,
or the tier that first loses money, fell in value. To protect
themselves, many hedge funds holding the riskiest tranches had bet
against slightly less risky tranches -- which turned out not to fall
in price nearly as much as the riskier tranches, causing the funds
pain anyway.

Investors in CDOs got a new dose of bad news yesterday when S&P
downgraded or put on credit watch credit-derivative structures
arranged by French banking company BNP Paribas SA. The move followed
similar decisions taken by the ratings firm against Deutsche Bank AG
structures the day before. S&P, which cautioned that the actions
affected only a small part of all BNP structures, hasn't identified
the assets tied to these derivative products, but many CDOs include
GM and Ford exposure.

In the wake of the GM downgrade, the price of buying default
protection in the CDS market has shot up. At one point yesterday,
the average annual cost of buying protection on $10 million in
investment-grade corporate debt rose to $76,000 from $71,500. The
price of that protection settled nearly unchanged by the close,

More important, though, bond and stock prices haven't moved in sync
with credit-default swaps -- or with one another. "Over the last
year, these credit-derivative indexes have been viewed as a life
preserver when we're in risky waters," said Geoffrey Gwin, a
portfolio manager at Group G Capital Partners, a hedge fund in New
York. "What we've seen is that when you're actually in the water,
these things don't float very well."

Severe problems in the convertible-bond market also have sparked
losses for hedge funds and other investors. The market for these
bonds, which pay an interest rate and can be converted into shares
at a preset price, has been crippled in recent days as investors
have become wary of the economy in general and auto makers in

Exactly how much money hedge funds are losing isn't known. Since
credit derivatives don't trade on public exchanges, those who bet
wrong can find it costly to unwind their bets. Hedge funds could
lose clients, especially if they have a poor performance in May,
forcing the funds to increase their sales of other assets to pay
exiting investors. "We expect a rush to the door to be painful,"
Merrill Lynch analysts warn.

"Many of these credit-derivatives products have not been well-priced
for the risk, so we have preferred to short them," says Andrew
Feldstein, founder of BlueMountain Capital Partners, a credit hedge
fund that is one of the winners amid the fallout in the credit

The clouds hanging over the bond market go far beyond losses at
hedge funds. The past two years saw many companies reduce debt and
strengthen their balance sheets. But now they are favoring
stockholders with raised dividends and share buybacks. And private-
equity firms, which accounted for more than 16% of all mergers and
acquisitions last year, have piled debt onto their portfolio
companies, leading to downgrades and concerns about the ability of
these companies to repay creditors. "Companies' stock prices are
starting to lag at the same time cash on corporate balance sheets is
high," says Mr. Kiesel of Pimco.

Most Treasurys rose as some investors shifted to government
securities amid concern over hedge funds. Longer Treasurys also drew
support from a belief that problems with private pension plans will
mean increased demand for those bonds.

Separately, in the second of its three quarterly debt auctions, the
Treasury sold $15 billion of five-year notes at a yield of 3.89%.
The bid-to-cover ratio, a gauge of demand, was 2.47, slightly below
the 2.49 average of the last 10 auctions. Indirect bidders --
largely central banks and investment funds -- took 34%, up from 28%
at the last five-year sale. Today, the Treasury will conclude the
week's auctions with a $14 billion sale of 10-year notes.

At 4 p.m., the benchmark 10-year note was up 4/32 point, or $1.25
per $1,000 face value, at 98 12/32. Its yield fell to 4.206% from
4.222% Tuesday, since yields move inversely to prices. The 30-year
bond was up 16/32 point at 112 15/32 to yield 4.549%, down from
4.579% Tuesday.

Investment-grade bond issuance surged as investors sought safety in
higher-rated debt issues. Among issues were $1.5 billion from triple-
A-rated Berkshire Hathaway Inc., $3 billion from triple-A-rated
European Investment Bank, $1.5 billion from double-A-rated Citigroup
Inc. and $350 million from double-A-rated Protective Life Corp.
During market volatility and uncertainty, it isn't unusual to see
higher-rated issuers taking advantage of a flight to quality, said
James Merli, global head of debt syndicate at Lehman Brothers in New

--Michael S. Derby and Christine Richard contributed to this article.


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