October 23, 2006 10:25 pm

John Dizard: An appetite for making free money

Free money. Profit – generated on billions of dollars of capital – without risk. Too good to be true, right? Tell that 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 should not 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”.

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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 do not 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 a third have negative basis spreads available that are more than 10 basis points. There are five or 10 names with more than 30bp. 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 $10m 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 cut of the profits should buy them two weeks or a month’s rent on a summer house in the Hamptons, depending on whether they want to be on the north side (less fashionable) or the south side (more fashionable, close to the beach) of Highway 27. And again, the credit and interest rate risk have been hedged away.

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), comprising 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.”

To eliminate the interest rate risk on the bonds, managers have to have their cash flows swapped into London interbank offered rate, which is done through the swaps market. David Goldman, the fixed income strategist at Cantor Fitzgerald, says that “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.

There are other pitfalls. As another credit manager says: “Look at News America bonds. They’re trading at a negative basis of 30bp, which is wide. But the dollar price of the News America 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 30bp of gain.”

Another driver of the negative basis trades is the prospect of leveraged buy-outs. In those, the trader’s CDS protection will rise due to the higher leverage in the company. 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.

This game is going on thanks to excess liquidity in the world, even after the central banks have supposedly tightened their policies. Chris Whalen, of Institutional Risk Analytics, 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.”

Fond as Wall Streeters are of comparing their work with battlefield heroics, people (such as me) are always talking about deals or trades “blowing up”. Now there is a takeover deal that looks as though it might blow up because a few real world things actually blew up.

At the end of August, Western Refining offered to pay $83 a share for Giant Industries, which owns three refineries. The idea was to build a 216,000 barrels a day, geographically diversified operation. It seemed like an aggressive deal, since Western was paying all cash, a premium of more than 15 per cent to the market and absorbing $275m in debt. Also, this could be close to the top of the refining margin cycle.

Then on October 1, the diesel unit of Giant’s refinery in Yorktown, Virginia, caught on fire and was shut down. On October 6, Giant’s Ciniza refinery near Gallup, New Mexico, was hit by another fire that shut down the refinery. This followed earlier fires at Giant refineries in 2004 and 2005.

The fires could raise questions about the adequacy of Giant’s maintenance practices, and repairs will add to the high acquisition price.

When I contacted Scott Weaver, a major Western shareholder and the company’s investor relations person, he said: “Giant is assessing the damage and the effects on operations. We are waiting for the facts; when we have them we will assess the situation.”

If you have Giant stock, I would sell it.

johndizard@hotmail.com

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