Hedge funds flock to riskiest derivatives
today.reuters.com
Fri Mar 31, 2006 5:41 AM ET
By David Wigan
LONDON, March 31 (Reuters) - European hedge funds are piling into the riskiest parts of complex structured derivatives as pressure to generate higher returns offsets concern over interest rates and record levels of mergers and acquisitions.
Dealers report a rise in sales of equity tranche protection in synthetic collateralised debt obligations (CDOs), the same investments that were hit last year following the downgrades to junk of U.S. auto makers Ford <F.N> and General Motors <GM.N>.
Sellers of CDO equity protection agree to reimburse buyers for the first 3 percent of defaults in a portfolio of up to 125 companies. The investments are lucrative because they are risky -- just one default can cause a 20 percent loss.
So difficult to gauge are equity tranches that they are unrated, while premiums are paid on a upfront basis, rather than the normal running premium elsewhere in CDOs.
Still, money has been flowing in, with hedge funds in the vanguard, as low returns elsewhere in structured credit push managers into riskier strategies.
"The equity shows exceptional value relative to senior tranches," said David Peacock, co-head of credit at Cheyne Capital. "An overweighting of money has gone higher up the capital structure into rated tranches (in recent months), but that has pushed spreads there too tight."
Late last year, super senior CDO tranches attracted volumes of cash as investors looked to shed risk following the May auto downgrades. Senior CDO risk also attracts a lower risk weighting for regulatory purposes than other highly rated investments, boosting its allure.
Fuelling the trend was the introduction of leveraged super-senior tranches, providing outsized yields for AAA-rated portfolios.
Now, however, super-senior spreads are trading at historically tight levels, and the benefits of the trade are less manifest. That has lead to a flow of value into other parts of the capital structure, particularly equity.
"Senior risk is fully valued," Peacock said. "The opportunity is to exploit the cheapness of that financing to buy into equity."
IDIOSYNCRATIC RISK
The sudden renewal of interest has pushed the upfront cost of selling protection lower. The premium on the iTraxx Series4 five-year equity tranche has fallen to 22.6 points in recent trade, compared with 26 points a month ago, and around 65 points following the U.S. auto downgrades last year.
Another way to interpret the move into equity is that investors are once more comfortable with exposure to idiosyncratic risk, or the chance of one-off defaults.
Sellers of equity protection bet against one-off events, such as auto industry defaults, while sellers of senior tranche protection bet against systemic or widespread risk, where spread behaviour is more correlated.
Investors that sell more equity protection are said to be long correlation (i.e., they think spreads are more likely to act in a correlated way), even though the current wave of European mergers and acquisitions, impacting individual companies, makes that seem counter-intuitive.
"You might say that these moves represent a shift in fundamental views, but what you have to remember is that these are highly technical markets," said Lorenzo Isla, a strategist at Barclays Capital. "What these investors are thinking about is relative value within the CDO universe -- the fundamentals come second." |
