Friday, February 20, 2009

Negative Basis Trading Recommendations

We have discussed the nature of the negative basis phenomenon at length previously, and judging by recent observations in the cash and synthetic market, it is evident that it is only a matter of time before this spread collapses dramatically, resulting in huge windfalls for accounts who establish basis positions currently ahead of a significant convergence in spreads.

As the below chart indicates, the basis has recently bottomed in both IG and HY names and has gradually commenced normalizing. Granted, assuming Citi and/or BofA are nationalized, it is possible to experience yet another risk flaring mostly due to liquidity considerations, which is why it is important to gauge for financially systemic events as basis trades are established.


What are the main reasons to believe bases will collapse?

1. Liquidity thaws and lowered funding costs coupled with economic deterioration.

Recent initiatives by the Fed, while unable to slow the dramatic decline in most macroeconomic indicators, have brought new life to the credit markets, where funding costs (for the survivors) have dramatically improved. Our weekly compilation of DTCC data shows that the notional and contractual value of CDS trades has been increasing over the past month and a half, by far the best proxy that accounts are getting back in the game. And due to the increasing economic risks, the default expectations will only increase, leading to accelerated hedging of bankruptcy risk via short risk synthetic positions.

2. Increasing risk of CDO unwinds.

We briefly touched upon the topic of CDOs and how they are closely intertwined in the fabric of the CDS world. More relevantly, AAA CDO tranches would be downgraded after a relatively small amount of IG fallen angels. Between 2006 and 2008 about $160 billion of CDO tranches (7%-15% range) were issued, which is the risk adjusted equivalent of $400 billion in notional of US and European collateral. And unlike junior and mezz tranches, the AAA tranches have been resilient (so far) to market volatility. Inevitably, downgrades and more MTM losses will generate more unwinds, which in a feedback loops, would only generate more losses and further unwinds, as previously discussed. The implication is single-name CDS spreads will widen and stay there for a long time.

3. CDS Clearinghouse will eliminate counterparty risk.

The imminent launch of a central CDS clearinghouse will increase margin posting requirements, but eliminate counterparty risk. Higher margin will have the impact of discouraging protection sellers as it will decrease the embedded leverage of running spread protection selling, while the overall improved robustness of the CDS market will encourage protection buyers and hedgers to return. Ultimately, this will also result in wider CDS spreads.

A relatively risk-free recommendation based on these assumptions is to purchase the following basket of investment grade negative basis opportunities (or alternatively to purchase the CDS outright, depending on risk tolerance). Below we present a robust and diverse selection of highly-rated (BBB thru A), and attractively priced bases. The median negative basis for the basket is at 384 bps, implying a basis convergence to 0 on a $100 million notional at a roughly $3,000 DV01 would result in positive P&L of $11.5 million, while picking up almost 4% in carry. Granted, this looked attractive to Boaz Weinstein as well, however, to generate the above return he needed to lever over ten fold, whereas the current market dislocation presents an impressive IRR on a purely unlevered basis.

(disclaimer, Zero Hedge has no current positions in either cash or synthetic credit instruments)
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2 comments:

doc holiday said...

Citigroup Inc convertible preferred shares issued in January 2008, for example, were quoted at around 18 cents on the dollar on Thursday, compared with around 25 cents on the dollar last Friday.

Wells Fargo & Co convertible preferreds -- originally issued by Wachovia in April 2008 -- fell to 40 cents on the dollar on Thursday from 55 cents at the end of last week. Wells Fargo acquired Wachovia at the end of December.

Preferred shares pay regular dividends, similar to a bond's interest-rate payments, but if a company files for bankruptcy, bondholders get paid back before preferred investors.

'There's a lot of talk of bank nationalization, which would cut off preferred dividends,' one portfolio manager said. When Fannie Mae and Freddie Mac were nationalized last year, their preferred shares lost almost all their value.

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Anonymous said...

any updates coming ?