Credit-Default Swap Market Whipsawed by Verizon, Rentokil Debt
bloomberg.com
Aug. 8 (Bloomberg) -- Companies in the process of restructuring are whipsawing the $346 billion credit-default swap market, where money managers bet on the ability of corporations to pay their debts.
Unexpected price changes for credit-default swaps, financial instruments typically based on corporate bonds and loans, are setting off alarms on the trading floors of the biggest banks and securities firms.
The most sophisticated investors are getting buffeted by Verizon Communications Inc.'s decision, for example, to spin off a directories unit, which forced sudden price fluctuations of as much as 30 percent a day for the credit-default swaps of the second-largest U.S. phone company. New York-based Verizon's focus on wireless communications and high-speed Internet services and its sale of the directories unit have made a muddle of the contracts. That's because traders don't know if the swaps will be related to Verizon or to the smaller, riskier directories unit.
Similarly, hedge funds were roiled after credit-default swaps of London-based Rentokil Initial Plc plunged 80 percent in value when the pest exterminator decided to issue debt through a new holding company.
The wild swings in credit-default swaps, which were created 12 years ago by investment bankers in London and New York, have become ``an unpredictable problem,'' says Stephen Rodger, who helps manage $3.8 billion of bonds at Baillie Gifford & Co. in Edinburgh, and has no intention of participating in the market any time soon.
Hedge Fund Nightmare
The predicament is akin to battling a rare disease because of the more than 1,000 companies with credit-default swaps bought or sold this year, fewer than 3 percent triggered price swings related to a change of corporate control, or so-called succession event, according to data from Frankfurt-based Deutsche Bank AG.
For hedge funds, unregistered pools of capital where managers participate substantially in the profits of the money invested, the volatility of credit-default swaps is a ``nightmare,'' said Simon Ballard, head of research in London at ARC Securities Ltd., a fixed-income broker. ``Credit derivatives have underpinned the evolution of the hedge fund community for the last few years.''
Even the International Swaps and Derivatives Association, the trade group that has championed credit-default swaps as tools to reduce risks in the debt market, is concerned that increased volatility shows the hazard that the contracts no longer reflect the value of assets they're mimicking.
These ``new problems'' are causing widespread confusion, said Kimberly Summe, ISDA's legal counsel in New York. Summe, who helps set the standards for credit-default swap contracts, coordinates a twice-monthly conference call with 150 bankers, investors and lawyers to tie the contracts more closely to a company's credit risk.
New York Fed
So far, regulators aren't voicing concerns. Last August, the Federal Reserve Bank of New York chastised some of the biggest financial firms, including New York-based JPMorgan Chase & Co., the third-biggest U.S. bank, and Goldman Sachs Group Inc., the most profitable securities firm, for allowing 150,000 credit- default swap contracts to remain uncompleted, leaving traders unsure of their obligations.
``We are working with the industry and are making significant progress on credit derivatives processing issues,'' said New York Fed spokeswoman Linda Ricci. ``Once these questions are resolved, we will determine if there are other credit derivative issues where our involvement could add value.''
In the U.K., ``at present it's not a big issue,'' said David Cliffe, a spokesman for the London-based Financial Services Authority. ``If it's a contract between two market participants, we tend not to get involved.''
Rentokil's Swaps
Prices of credit-default swaps, which enable traders to bet on increases and decreases in corporate indebtedness, fluctuate the most when companies surprise speculators by announcing mergers and acquisitions, spinoffs, leveraged buyouts and other corporate restructurings. The volatility of credit-default swaps is increasing on a record $2 trillion of takeovers this year, up from $1.5 trillion in the same period of 2005, according to data compiled by Bloomberg.
The increase in M&A has helped make credit-default swaps the fastest, growing part of the market for derivatives, financial instruments derived from stocks, bonds, loans, currencies and commodities, or linked to specific events like changes in the weather or interest rates.
General Motors
Rentokil, whose credit-default swaps increased through 2005 on speculation a profit slump would trigger a debt-financed acquisition, caused prices to plunge after it stopped selling bonds through one subsidiary and started borrowing with a new holding company.
For investors in credit-default swaps on Rentokil Initial 1927 Plc, the previous financing unit, the switch meant there would be no debt left within three years. Prices for five-year contracts on 10 million euros ($12.8 million) of debt dropped to as little as 19,000 euros in May from more than 100,000 euros last year.
``It's not a good thing for the market if people can make or lose money on a technicality instead of investment decisions,'' said Neil Murray, who helps manage about $27 billion of corporate debt at Scottish Widows Investment Partnership in Edinburgh. He ended up profiting after betting Rentokil's credit quality wouldn't deteriorate. ``The next time around, people will be less happy to buy'' the contracts.
Banks led by JPMorgan created credit-default swaps in 1994 as a way to reduce their lending risk. The contracts usually rise as credit quality deteriorates and prices of bonds and other debt securities fall.
When Standard & Poor's, Moody's Investors Service and Fitch Ratings cut General Motors Corp.'s credit ratings to below investment grade last year, the credit-default swaps soared. Investors were paying as much as $2.9 million to protect $10 million of the automaker's bonds in December.
`Think Twice'
Credit-default swaps also are used by money managers as a cheaper and quicker alternative to buying and selling bonds. When Delphi Corp. filed for bankruptcy on Oct. 8, there were $20 billion of credit-default swaps related to its $2 billion of bonds.
``Investors are thinking twice about buying credit-default swaps because they're wary'' of companies eliminating debt or not having enough bonds to meet the needs of the contracts, said Christian Evans, who helps manage 1.3 billion euros of debt and derivatives at Credaris Portfolio Management in London.
Price Swings
Even companies considered safe bets have shaken the market. Verizon, whose bonds have investment-grade ratings of A3 from Moody's and A from S&P because of the company's steady revenue, hammered investors last month when it announced a plan to split.
Verizon's credit-default swaps more than doubled to $79,000 from $37,000 on July 6, a day before the company announced the split, data compiled by Bloomberg show.
Bondholders, by contrast, have reduced the risk premium they demand to hold Verizon's notes because they're likely to be compensated if the company decides to make the directories unit responsible for any of its debt. The difference between yields on Treasuries and Verizon's $500 million of 5.35 percent bonds due in 2011 narrowed by 9 basis points to 80 basis points, according to Trace, the bond price reporting system of the National Association of Securities Dealers. A basis point is 0.01 percentage point.
``Bondholders typically get taken care of because companies want to maintain good relationships with investors so that they can access capital markets in the future,'' said Matthew Mish, credit strategist at Barclays Capital in New York. ``The fate of the same company's credit-default swaps is determined by the ISDA definitions, and the rules are the rules.''
Verizon's credit-default swap prices have swung by an average 10 percent a day in the past month, compared with less than 1 percent for the bonds.
Market Rocked
Other companies that rocked the market include VNU NV, the owner of Billboard magazine, which was acquired by a group led by Kohlberg Kravis Roberts & Co. Haarlem, Netherlands-based VNU's credit-default swaps doubled to a record after it announced a sale of bonds last month that would rank behind $1.4 billion of debt issued by another VNU unit in the event of a bankruptcy.
GUS Plc, the U.K.'s third-largest retailer, caused the credit-default swaps based on its debt to plunge 32 percent last month as the London-based company announced a spinoff of its Experian credit-information unit from its Argos and Homebase store divisions.
Credit-default swaps based on Alltel Corp., the fifth- largest U.S. mobile-phone company, dropped by 76 percent after the Little Rock, Arkansas-based company spun off its local telephone division on July 17.
`Market Disruption'
It's ``a market disruption that doesn't make much sense, and it has to be corrected,'' said Florian Grandcolas, deputy head of credit research at Axa Investment Managers in Paris, which oversees $115 billion of bonds, loans and their derivatives.
The turbulence is unlikely to hold back the expansion of credit-default swap trading.
The market is ``too important,'' said Gregoire Pesques, who helps manage about $30 billion of bonds and derivatives at Societe Generale Asset Management in Paris. He declined to comment on specific holdings. The credit-default swaps ``problem'' caused by corporate restructurings ``isn't going to materially change the liquidity.''
As long as the price swings persist, money managers such as London-based Gartmore Investment Management will limit their involvement.
``Investors have learned the hard way,'' said Karl Bergqwist, a Gartmore fund manager who helps oversee about $28 billion of bonds and credit-default swaps. ``You can get the credit analysis absolutely spot on and still wind up losing a lot of money.'' |
