With the rumours swirling, the long the senior debt short the equity trade, has always bothered me, mainly because of the volatility of the equity is so much greater than the debt? My question is, what are these guys trading off? A model of how the equity and debt should behave because if thats what they are up to I am not surprised they are seeing their arses. Next question in the event of forced liquidations which convertibles and corporate debt offer value?
but how can a hedge fund or two going down tank the whole market that much. I mean, we've seen billion dollar restatement have less of an impact, and this is supposed to be something like a $500 million loss, right? I'm sure I'm overlooking something.
The whole problem with the hedgies is multifold. First many hedgies are down 3 months in a row.. which will spark widespread redemptions forcing liquidations.. most likely coming from equity because thats usually the easiest to liquidate and many funds are still sitting on huge winners from the equity markets. Also.. many sophisticated investors now realize that with short and long term rate spread narrowing and with GM shock... most of the fixed income and interest rate hedge plays are not going to work well anymore... they are starting to get rid of all these speculative investments.. and better off putting money into CD's money market.. yielding almost 4%... and will probably be over 5% by year's end.
Good points. I don't see a spiral though. Even if things got nasty, you could see the "carry trade" had numbered days long ago. A few might have some dents in their numbers from the GM issues, maybe big dents. If a few funds had that much concentration in one or two positions, it might be better that they get taken out. There may be more bloodshed coming as these funds get further underwater...if they do. If they get far enough under, the fees nearly stop (for a long time), employees leave, redemptions go up and the funds may liquidate if things don't turn up. This "house cleaning" is a good thing for the industry as the strong will survive and prosper. With all the new regs both on the commodity side and SEC side, it should be more difficult for someone to shutter a fund and come back with a new name. The principals are required to disclose past funds and performance on ADVs and DDs.
No, that's not it - it's coming from CDO world "equity vs senior", not stocks vs bonds. A number of hedge funds engaged in what is known as "correlation trading". The structures that provide for this kind of trading the best are CDO (Collateralized Debt Obligations). CDOs in a sense are baskets of low-grade bonds. The pay from these bonds is split into tranches, tranches are paying in what's called "waterfall" structure. In short, senior tranches pay always and are rated AAA. So, if something defaults, they still pay their coupon. Mezzanine tranches are the first to recieve everything that's left after senior tranches. On the very bottom, there are "equity" tranches, which are piles of shit paying very high coupon. So, given this structure, you can find "arb" in form of payment/probability mismatch. Let's say mezz tranche paying 5% with 5% default probability for every bond, while equity tranche is paying 25% with 15% default probability for every bond. It's only natural to say - well, let me buy 1 unit of equity tranche and sell 3 units of mezzanine tranche to be hedged against default. Nice carry of 25 - 5 * 3 = 10%. Free money, right? The only problem is that if a bunch of companies decide to default at the same time, your equity tranche will suffer much more. In a sense, you are buying implied correlation vs historical correlation. That's exactly what happend in the past few months (automakers all correlated) and since the tranche purchase are financed on margin (well, repoed out, which is the same thing), some positions had to be unwound. Some big positions, to be specific. That's what we see.
Thanks great explanation. Yeez to me you need to estimate correlations in an extreme environment. Basically you are on the tail of the distribution. Very little data out there. Now are any corporate debt names trading at stupid levels as a result of the unwindings. Could be some good ways to make money out of this?