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The rapid tightening in risk spreads over the past few weeks has left portfolio managers in a bad way. There just isn’t much discernable value out there. Now they’re picking through the rubbish piles of junk bonds looking for scraps of yield they can take back to their hungry clients. If their situation gets any more pathetic, they’ll have to recruit Bono to raise their year-end bonuses.

A lot of people were defensively positioned as the holiday season started, which I would have thought was a good plan. Except that everyone else did it. Then they frantically bought back risk. A Bank of America report says: “With the recent rally in credit spreads, relative value in the high-yield market has worsened considerably. Our long-term LGD valuation model now indicates the market is rich by 81 basis points.”

Well, we may have one last idea, other than going short and waiting for an attack on Iran. The standard pricing models for credit default swaps may, in the case of some industries and issuers, understate the possible recoveries in the event of default. So, by leveraging up the riskiest slices of credit for industries in which recoveries are, you believe, going to be better than average, you may be able to find a tiny bit of alpha with which to pay the school fees.

The industry I have in mind is the US electric utility sector. Most of the time, utilities don’t go bankrupt. But sometimes they do. Typically, they over-build plant at the wrong point in the cycle. Then the public and the regulators get angry. The utility management tries an ineffectual fix. The fix blows up. The public screams. The utility defaults. The public and politicians consider the attractions of life without air-conditioning. An even more expensive fix is put in place. All the defaulted debt is funded and paid back at par plus accrued.

Now look at one US utility under the supervision of a bankruptcy court, Entergy New Orleans. After the hurricane devastated the city, it had no choice but to file. The city has perhaps half its original population. Yet the utility bonds, which I liked in late 2005 in the 70s price range, are now selling in the mid to high 90s, as a percentage of face value. Someone else can own them here but consider this: the standard recovery rate assumed in credit default swap pricing is 40 per cent.

Here’s the idea: using the credit default swap market, you sell protection, or go long, a basket of US utility names, using first-to-default baskets. That means, assuming you are doing this with a group of, say, five to 30 names, offering to pay back the counterparty par on the first default realised in the basket.

At the first default, the counterparty gets cash, you get the bonds put to you. As long as there is no default, you collect contracted payments over, say, a five-year period that will come to several hundred basis points over Libor, close to an equity-like return premium.

The mispricing that would be in your favour, if there was one, would be in the recovery rate. You have to be willing to bet that you will recover more than the standard 40 per cent rate calculated in the Bloomberg model, or with the recovery rate assumed in the CDS dealers’ pricing.

As I explained above, you should be willing, on the basis of the utility industry’s historical record, to take back defaulted utility bonds.

In this model-driven market, most risky assets are overpriced, but some are underpriced, because not enough people do actual credit analysis that is industry or company specific.

As a recent Morgan Stanley report on first-to-default baskets says: “The advantage of this market is that investors can customise maturity, and the amount of leverage they apply to a portfolio [through the size of the portfolio]. These FTD basket structures are relatively simple to understand when compared to tranches and other large basket products that get much more press . . . the leverage comes through the fact that the exposure is limited only to the first name in the portfolio to default, and no other, thus putting a cap on the absolute national exposure.”

Morgan Stanley’s credit strategists suggest industries other than US utilities where investors could use first-to-default baskets as a substitute for equities. Autos and auto component manufacturers, as well as telecommunications services companies, are considered more attractive as credits than straight equity investments.

Think of it this way: where there’s not much in earnings growth but a higher-than-discounted level of stability in cash flows available to service debt, you could be better off leveraging credits than buying shares.

Of course, the risk is that someone can use a sharper pencil than the Bloomberg analytics package. As a credit strategist with a big dealer says: “I know some hedge funds had a great time with Wall Street last year on single-name CDSs. GMAC’s recovery rate was really worth 60 cents, and they were able to buy it at 40 cents. Speaking for our firm, we are not using a 40 per cent recovery assumption on every name.”

Such arbitrages among risky assets should, in theory, be quickly arbitraged away. They’re not, though. As one credit trader says, “People live in silos. The credit people and the equity people don’t talk enough to each other.”

Easy? Simple? No. But there isn’t much alpha out there for all the people on the rubbish heap, going forward, as they say.

johndizard@hotmail.com

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