leverage interest rate~ Oh the seductive leverage-I remember an option strategy called the butterfly spread...PIMCO had Bill Gross, a bond guru as their expert leader~He was to bonds as Warren Buffett was to stocks!. Interesting strategy..what's the downside? BBB may not qualify as junk, but it does not qualify as AAA AA A or lower yielding "better balance sheet" paper...

Date:   10/25/2005 7:55:28 PM ( 19 y ago)

Not Your Father's CD

Banks are pitching credit derivatives as a source of higher yields for cash-laden companies. But as always, higher yields mean higher risks.

Ed Zwirn, CFO Magazine
October 15, 2005

With interest rates still low by historical standards and spreads tight, corporate finance professionals are facing a win-lose situation: funds have remained cheap for much of 2005, but yields on cash have also stayed low. Compounding the problem, cash on corporate balance sheets has ballooned with rising profits but unimpressive reinvestment opportunities.

That puts new pressure on treasurers to both minimize the cash they keep on hand and maximize returns on what remains there. "A corporation needs a certain amount of liquidity that serves as a backstop," says Stephen Baird, project manager at Treasury Strategies, a Chicago-based consultancy. That said, he adds, "the more precisely you're able to forecast, the less need you have for that cushion."

That's a particular challenge for midsize and smaller companies. David Kay, CFO of Capital Automotive, a McLean, Virginia-based REIT that invests in auto dealerships and has nearly $2.5 billion in assets, says he tries "to run everything at a zero balance. As we get capital in from rent, we try to pay down borrowings as fast as we can." But there is still cash to park from time to time. In May, advised by the 12 banks in Capital's lending syndicate, Kay was able to take out a three-year certificate of deposit from a regional bank with an option to prepay without penalty. The CD, which was worth "several million," yielded "north of 4 percent" and was held for about eight weeks, he says. At the time, three-year CDs on average yielded only about 3.4 percent, and, of course, that would have been reduced by a prepayment penalty for withdrawing after only two months. And a money market fund would have yielded less than 1 percent over that period. However, even a tailor-made CD wasn't enough to prevent Capital from being put up for auction, as the company was in negotiations to be sold as this issue went to press.

In similar situations, other treasurers may be tempted to tap into the growing array of alternatives to standard banking vehicles such as money market instruments and certificates of deposit, even if they do offer such pluses as no early-withdrawal penalties. Many treasurers, particularly at large companies, now park cash in the Treasury repurchase market, for instance, by lending their holdings of government securities to investors through dealers, usually on an overnight basis. Some companies, including Berkshire Hathaway, are also venturing into the foreign exchange markets (see "Gaining Currency," CFO, April), which may naturally appeal to multinationals needing to hedge currency risk anyway. Yet none of these alternatives may add all that much to returns. And the obvious way to boost returns — moving down the credit curve toward investments rated triple-B and below — brings too much volatility for many treasurers.

To be sure, one can reduce such volatility while generating market-beating returns through hedging and arbitrage strategies. Theoretically, the simplest means is to buy an index of corporate bonds and trade against it. This is done by going long or short on differently rated classes — or tranches — as their spreads widen or narrow in relation to their benchmarks. But this approach isn't always possible, because there may not be enough bonds available in a particular class at any given moment. And even if there are, the cost can be prohibitive.

Time for Derivatives?
So now banks are touting credit derivatives as a more readily available and affordable alternative. These contracts, under which the seller protects the buyer against the risk of default by a third party (or even itself), are typically and increasingly used as proxies for the exposure to credit risk that corporate bonds pose. (For a look at how banks use these derivatives to lay off their exposure to corporate credit risk, see "Who's Holding the Bag?")



The market for these instruments took off in late 2003 in Europe, where corporate bonds are even harder to come by than in the United States and investors are unencumbered by accounting requirements that derivatives be regularly marked to market, as FAS 133 in the United States had already required.

Seeking to generate similar momentum in the United States, Dow Jones launched an index of credit derivatives known as the CDX Index around the same time. The emergence of CDX, says Merrill Lynch credit strategist Michelle Charles, is the reason that credit derivatives have surpassed equity derivatives in notional terms over the past two years. The credit-derivatives market is now estimated to be more than $8 trillion by the British Bankers Association, with collateralized debt-obligation deals reflecting $131 billion of structured credit risk done in 2004, according to a May report issued by bond fund manager PIMCO.

What an investor buys when purchasing an investment-grade CDX contract is the risk of default on the underlying debt of 125 of the most widely traded investment-grade credits. To hedge that risk and engage in arbitrage, many investors also take long and short positions in different tranches. Trading all the components against the index can generate market-beating returns with "basically no credit risk," says Charles.





 

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