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Bond market derivatives now offer profit without risk

Section: Daily Dispatches

A Billion-Dollar Game

By John Dizard
Financial Times, London
Monday, October 23, 2006

Free money. Profit -- profit on billions of dollars of capital -- without risk. Too good to be true, right? Tell it to the people putting on "negative basis trades."

Over the past few months, professional managers of US dollar bond portfolios have been buying corporate bonds, then buying the credit default swaps (CDSs) that allow them to cover the default risk on the bonds. That shouldn't be profitable, but it is. Usually, the cost of complete CDS protection will be greater than the coupon on the bonds; the difference is called the "basis".

Now, though, thanks to a bizarre anomaly in the financial markets, the cost of protection using the CDS market is less than the interest yield on the bonds. So we have "negative basis". You are being paid for taking the risk of owning corporate credit, but you don't have to take the risk.

How much are you being paid? That depends on the bond. Of the 150 most frequently traded corporate names in the US bond world, about 50, or a third, have negative basis spreads available that are more than 10 basis points. There are five or ten names with more than 30 basis points. That may not sound like a lot, but on billions of dollars, it adds up.

The bond manager, can, without difficulty, buy 10 bond positions of $10 million each, buy the corresponding CDS protection, and collect $100,000 a year of risk-free money.

For a short morning's work, the trader's own cut of the profits should buy him two weeks or a month's rent on a summer house in the Hamptons, depending on whether he wants to be on the north side (less fashionable) or the south side (close to the beach) of Highway 27. And again, the credit and interest rate risk have been hedged away.

Of course, the forthcoming congressional elections are being fought over other master plans that entailed no risk.

So the more thoughtful are picking up this trade and shaking it to see what parts come out, if, for example, credit spreads widen dramatically in a more nervous environment. Mike Mutti, co-head of corporate credit strategy and managing director of Bear Stearns, says: "Such a position -- that is, buying bonds and buying CDS -- would likely perform well, since CDS typically widens much more than bonds when spreads widen."

There were two forces that created the negative basis trade opportunities. One was the demand for "synthetic" collateralised debt obligations (CDOs), comprised of portfolios of CDS contracts that could be sliced into convenient high- and low-risk components. The other was a favourable interest rate swaps curve.

As Mr. Mutti says: "Typically, negative basis trades are not very common. However, strong demand for synthetic CDOs over the summer contributed to tighter CDS spreads, while bond spreads underperformed due to higher financing and hedging costs.

"Consequently, when the bulk of investors returned from the summer, they found numerous opportunities to buy bonds and buy protection on the same name and have positive carry."

In order to eliminate the interest rate risk on the bonds, they have to have their cash flows swapped into Libor, which is done through the swaps market. David Goldman, the fixed-income strategist at Cantor Fitzgerald, says: "The interest rate swap curve has traded within a very narrow range for the last two months. By far the biggest influence on the swaps market is the yield curve and mortgage duration." These have kept swap spreads tight, which lowers the cost of the negative basis trades. "In a very volatile market," Mr Goldman adds, "you can get a flight to quality, as we did in May," which reduces the value of the negative basis trades.

There are other pitfalls. Another credit manager says: "Look at News America bonds. They're trading at a negative basis of 30 basis points, which is wide. But the dollar price of the bonds is 117.

"If the bonds were to default, the CDS you bought to hedge away their risk would only pay you par for the bonds, so you would have 17 percentage points of potential loss against only 30 basis points of gain. But there are people who say the chance of default is low, so they will take that risk."

Another driver of the negative basis trades is the prospect of leveraged buyouts. In the event of a buyout, the CDS will widen out on the risk imposed by the higher leverage in the company.

So the bond trader would profit on that leg of the position. But because corporate bonds often have restrictive covenants in them, the LBO sponsors will buy them back, frequently at a premium to the previous market price. The trader would profit on that leg as well.

This game is going on thanks to the excess liquidity in the world, which is still there even after the central banks have supposedly "tightened" their policies. Chris Whalen of Institutional Risk Analysics says: "It's kind of sad. People are running out of ways to deploy their capital intelligently, so they turn to this kind of financial masturbation, trying to get their performance far enough inside the herd so they don't have to deal with redemptions."

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