Institutional Investor's Alpha Magazine - May 2008 - (Page 37)

Boaz Weinstein What’s the impact been so far? It has really affected everything from the shape of the U.S. yield curve to the yen carry trade to Asian equity prices and even gold prices. One of the last places where things remain out of step is Europe, where the European Central Bank has not cut rates. But really everything else has coupled. Why do you think so many people bought into the decoupling idea? I remember talking to the people in equities and even the people in emerging markets, and they would all say the same thing: “You don’t understand. The fundamentals look great.” So emerging-markets fundamentals looked great because of high commodities prices. Or people would say that equity prices were reasonable because the S&P trades at a decent price-to-earnings multiple. And they kept looking at what was happening in high yield as a technical thing that should not affect them. Clearly, since then we have seen the slowdown in the economy and the potential for a recession. But corporate credit had been overvalued. daily basis. The old-style cap structure arbitrage of the 1980s and 1990s focused mainly on distressed companies. But what we are looking for are the largest dislocations across distressed, high-yield and investment-grade companies — not just fundamentally, but also quantitatively. Factors like equity volatility and implied recovery come into play. We are looking for dislocations across hundreds of names. There are groups with experience through different market cycles that are well versed in equity derivatives, credit derivatives, recovery analysis and credit spreads. Is this a typical trade for Saba Capital? Actually, from 2005 through early 2007, Saba was short credit and long equities. During that period companies were actively looking for shareholder-friendly transactions at the expense of bondholders, whether it was an LBO or a share buyback. That regime was exactly the opposite of what we are experiencing now. It is important to take note of what the companies themselves are doing to change their capital structures. One good capital structure arbitrage trade for Saba and others was with Countrywide Financial. The trade was to buy credit and hedge it with out-of-themoney puts on the stock. Yes, and people could cling to that a bit because spreads had been very narrow. High yield was technically overvalued into June, but it fell to the point of being extremely undervalued compared with other asset classes. There was such risk aversion because of all of the subprime losses at banks that spreads on corporate credit widened too much. But surely default rates are going to rise? Yes, defaults are going to increase. But credit spreads now are already implying a default rate higher than during the bear market of 2000 to 2002. During that period the S&P tumbled 45 percent, default rates were at an alltime high and recoveries were low due to frauds such as Enron and WorldCom. Today default rates are at historical lows, recoveries have been decent and the decline in equities is much more mild, but credit spreads are practically at 2002 levels. Why are some traditional long-short equity hedge funds now looking at getting into credit and credit derivatives for the ﬁrst time? Yes. If you look at recent examples of large companies that have had problems, the bondholders tend to come out ﬁne. In the case of Countrywide, for a while the stock dropped and credit spreads widened. Countrywide credit default swaps went from 320 basis points in mid-October of 2007 to almost 1,700 basis points on January 9. Following Bank of America’s announcement that month of its intent to purchase Countrywide, the equity has languished, but the credit spread has narrowed by 1,400 basis points and the bond price has risen by 40 percent. The exact same thing happened with Bear Stearns after JPMorgan announced its acquisition. Why is this kind of arbitrage so attractive right now? In good times credit has always been viewed as offering a small premium but, if things were really wrong, you could suffer a default. So there was relatively little upside and the potential for downside. High yield is so depressed right now that the risk-reward looks much more symmetric, more like equity. Where do you see opportunities? We are at a point in the cycle where stressed ﬁnancial and insurance sector ﬁrms have little choice but to substantially dilute the existing equity investors. They are doing it by issuing equity and preferred stock to save the enterprise. The same thing happened in 2002, and you are seeing it a lot with the banks now, with all the sovereign wealth funds coming in and diluting the equity. But it’s not always going to be proﬁtable. We have been going long some high-yield credits and selling the equity as a hedge; it has been a very proﬁtable enterprise for us. There aren’t many hedge funds involved in this type of capital structure arbitrage on a If we were to enter a period where a lot of these companies started defaulting, it could certainly become more challenging. On an individual basis these trades can be volatile and remain dislocated for periods of time. Of course, I’m not presenting this as a risk-free trade. But over the years capital structure arbitrage has been very proﬁtable for us. MAY 2008 • INSTITUTIONAL INVESTOR’S ALPHA • 37

Table of Contents Feed for the Digital Edition of Institutional Investor's Alpha Magazine - May 2008

Institutional Investor's Alpha Magazine - May 2008 Contents Letter from the Editor Longs & Shorts Pension Corner: Send in the Clones The Good Guys: Outside the Box Cover Story: Welcome to Oz Interview: The Tipping Point Regulation: When Sentinels Go Astray Strategies: Taking Credit Research Center: The Hedge Fund 100 Book Excerpt: Shoot the Messenger Alpha Bytes: VaR Enough? Unhedged: Commentary: Not Your Father's Activist

Institutional Investor's Alpha Magazine - May 2008

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