FROM Bill Gross---PIMCO---on hedge funds :
But there are fresh negatives to haunt the traditional corporate bondholder that emanate from the growing power of hedge funds and their willingness to play fast and loose with the solvency of struggling companies. Let me say at the outset of this thesis that I have little proof. No hedge fund has admitted their machinations to me. My corporate specialists and I, however, see things every day now that were not happening several years ago. We hear the rumors. We might, just might be on to something so take it for what it's worth: a Maybe with a capital "M."
The game is played as follows: Just as lions cull the weakest and slowest from the Zebra herd, hedge fund managers prey on disabled or temporarily injured companies by shorting their bonds. Corporations with high debt levels, SEC investigations, accounting improprieties, earnings shortfalls, or other blemishes are the obvious targets and perhaps rightly so. Shorting is a legitimate form of arbitrage and an age-old investment technique of sophisticated investors. They help to keep the "herd" of corporations healthy, if only by rapidly adjusting prices and signaling to the market and management alike that something might be amiss. But while this works efficiently with stocks, the technique has more destructive power in the bond market than may be healthy over the long run. The reason for the difference is that bonds are divided into two distinct groups: investment grade and junk. Many institutions and investment managers are limited by law, fiat, state regulation, or simple internal guidelines to the higher quality Baa and higher spectrum, so that in the case of a downgrade to junk status they are "forced" to liquidate.
Knowing this requirement for forced institutional sales at the stroke of a downgrade, hedge funds find the vulnerable Baa Zebras and begin the chase. Selling bonds holds little near term risk because of these companies well publicized problems, and once they get prices moving by one, two, five points on the downside they solicit an unsuspecting innocent ally in their game: the rating agencies. Hedge funds and everyone else for that matter, know S&P, Moodys, and Fitch are extra sensitive to the perception that they moved too slowly with ENRON and other corporate rating disasters. They know that the agencies watch bond prices and bond yields in addition to a myriad of other indicators as a clue to the quality of a corporation's debt. And so by pushing a company's bonds down in price and up in yield they sometimes, SOMETIMES, can initiate an agency downgrade into the world of junk bonds and out of the world of investment grade which in turn precipitates the forced liquidation of some institutional holdings. The hedgies can now do one of two things: they can cover (buyback) their shorts at prices 5-10-15 points lower due to the downgrade or they can press their bets - selling a few more in a frightened and illiquid market - and hoping for further downgrades by the agencies due to the negative price action. Either way, in the midst of accounting scandals, legitimate SEC and government investigations, and a genuinely negative PR environment for corporations, the game results in billions of dollars of profits for the hedgies.
So is this a bad thing? Buyer (or seller) beware you say and I'd agree. This is not a Poor PIMCO or an George Romney "I've been brainwashed" thesis. But it's a heads up to corporations and investors alike that due to the increasing clout and financial firepower of hedge funds that the game has changed in the past few years. In addition to traditional credit - and yes J.P. - corporate character analysis, investors must now factor in a momentum driven, Soros-like reflexivity behavior into their portfolios of corporate bonds. If you can't handle a downgrade to junk status, perhaps Baa rated bonds should be off your plate as well. And corporate CEOs and Treasurers should understand that the fate of their company lies not just within, nor even with their increasingly reluctant-to-lend bankers, but with bond holders and the hedgies that are beginning to dominate the financial and investment horizon. Once downgraded to junk, it's a long road and a long time back to the promised land of investment grade. Corporate survival and access to capital will undoubtedly be jeopardized because this is so.
Corporate bond prices and yield spreads are also being seriously affected by the withdrawal of banks from the short-term lending arena. For decades, bank "lines" have been a standard foundation for the commercial paper market and a perennial piece of banking business that was tied to underwriting fees for investment banking subsidiaries. As such, the "lines" were in many cases granted for "free" or without pricing consideration as to their inherent risk. Longer-term corporate bond valuations were explicitly tied to the granting of these lines and the subsidy pricing. In short, narrow corporate spreads in the late 1990s/early 21st century were artificially low because bank "lines" not only were available but represented little cost to the borrower. Now these lines are being withdrawn or drastically reduced even for high quality corporations, forcing companies to term out debt and pressuring yield spreads wider. In addition - and this is critical - the remaining lines are being hedged by the sale of "credit default" swaps. These swaps are overwhelming traditional corporate bond buyers based on the sheer dollars of supply, blowing out spreads on the front end of the credit curve and pressuring intermediate and long term spreads in the process. To state the problem succinctly - the corporate lending market has lost a huge supplier of funds as the banks have begun to recede from traditional lines of business. The vacuum can temporarily only be filled by much lower prices and wider yields that attract cross-over buyers from stocks and high yield constituencies.
Together, the arbitrage activity of hedge funds and the withdrawal of banks from the short-term lending market have devastated corporate bonds in recent months. Bond managers should do several things: First they should recognize that yield spreads will not return to the narrow levels of yesteryear no matter how strong an economic recovery we have. Secondly, they should find those corporations with attractive long-term fundamentals and J.P. Morgan-like "character" and stick with them. There is a high degree of irrationality in some areas of the market at the moment (Sprint, ATT, selected energy companies) due to these new age corporate bond market realities. The task is not to whine or complain but to find the healthy Zebras with sound body and stalwart character and survive to manage money another day. After all, it always has been a jungle out there, now hasn't it?
William H. Gross
Managing Director |
