AllianceBernstein Finds ‘Free Money’ in Wrecked Trade (Update1)

By Shannon D. Harrington Jan. 23 (Bloomberg) -- AllianceBernstein Holding LP and TIAA-CREF are betting they have better timing in the credit markets than hedge fund Citadel Investment Group LLC and Deutsche Bank AG. They are part of a growing number of investors seeking to profit from a record-wide difference between corporate bond yields and the cost of protecting the securities from default. The gap exceeded 8 percentage points in some cases last month, meaning an investor would earn $800,000 a year for every $10 million put into the trade. At their core, so-called negative basis trades are essentially bets that the worst of the seizure in credit markets is over. That’s what Frankfurt-based Deutsche Bank thought before Lehman Brothers Holdings Inc. went bankrupt in September, costing the firm $1 billion, while funds run by Chicago-based Citadel fell 55 percent in value last year, in part because of the trades, according to people familiar with their strategies. “Whoever was in the trade at that time found out that it’s not a free money trade,” said Steve Sterman, head of fixed- income trading in New York at TIAA-CREF, which oversees $398 billion in assets. “There’s no such thing as free money.” In a negative-basis trade, investors buy bonds such as the 8.125 percent notes due in 2013 issued by Little Rock, Arkansas- based phone company Windstream Corp. Buying Protection They then purchase credit-default swaps, which pay the buyer the face value of the bonds in exchange for the securities should the company fail to honor its debt agreements. Banks charge about 2.5 percentage points a year for five years of protection on Windstream debt, according to CMA DataVision. Since the Windstream notes yield about 7.3 percentage points more than benchmark interest rates, investors get 4.8 percentage points net of fees for the credit-default swap contract. The potential profit increases if the gap narrows and the investor sells the bond and exits the contract. For investors able to hold onto the trades, the positions are “extremely attractive,” said J.J. McKoan, who oversees about $65 billion as director of global credit at AllianceBernstein in New York. McKoan said investors last month could find basis trades on investment-grade companies paying 5 percentage points to 6 percentage points and as high as 8 percentage points. That compares with an average of 0.5 percentage point before Lehman’s bankruptcy, data from Citigroup Inc. strategist Mikhail Foux in New York show. Citadel Burned Deutsche Bank trader Boaz Weinstein, 35, and Citadel Chief Executive Officer Kenneth C. Griffin, 40, were burned last year when Lehman’s collapse forced corporate bond yields to rise at a faster pace than the cost of credit-default swaps. The difference swelled to more than 2.74 percentage points on average in November as credit markets seized up, according to the Citigroup data. The average over the five years before that was less than 0.2 percentage point, the data show. A Deutsche Bank unit led by Weinstein lost about $1 billion as of mid-December partly because of bad basis trades, said people familiar with the matter who declined to be identified because the circumstances haven’t been disclosed publicly. Weinstein, who is planning to leave Deutsche Bank to start a fund, and Michele Allison, a spokeswoman for the firm, declined to comment. Citadel’s two biggest funds were down 55 percent last year in part because of bonds that were hedged with credit-default swaps, people familiar with the matter said. Citadel spokeswoman Katie Spring declined to comment. No Financing The difference also widened as banks and hedge funds that used borrowed money to amplify returns abandoned the trade after a surge in the cost of financing purchases. “The fact that we are a AAA rated company with a large balance sheet allows us to go out and execute on our own without relying on financing,” Sterman said. They’re betting that the government’s attempts to unfreeze the credit market will bring corporate bond yield spreads more in line with the credit-default swap market. President Barack Obama’s administration is working on an $825 billion fiscal stimulus plan. The Federal Reserve has been working to unlock the credit markets, and on Dec. 17 lowered its target interest rate for overnight loans between banks to a range of zero to 0.25 percent. The central bank pledged to use “all available tools” to help revive lending and reverse the nation’s yearlong recession. “It could always go wider and remain volatile, but at today’s levels, you have significant compensation for basis spread widening,” McKoan said last month. Trade Tesoro Barclays Capital analyst Gary Stromberg in New York recommended two weeks ago that investors buy the bonds of San Antonio-based oil refiner Tesoro Corp. and purchase credit- default swaps. The difference at the time was 5.5 percentage points, meaning every $10 million invested would earn $550,000 a year. The trade has paid off for those who got in at the peak. The gap on the Tesoro trade has since narrowed to about 3.2 percentage points, Stromberg said. For the broader market, the average difference has narrowed to 1.73 percentage points, Citigroup data show. Masco Corp.’s $200 million of 7.125 percent notes due in 2013 traded Jan. 21 at a spread of about 10.3 percentage points, according to Bloomberg data and Trace, the bond-price reporting system of the Financial Industry Regulatory Authority. Five-year credit-default swaps tied to the debt of the Taylor, Michigan- based company, which makes Behr paints and Delta faucets, were trading at 5.1 percentage points less, according to CMA DataVision. Improving Transparency An effort to mitigate the risk of credit-default swap dealers defaulting by having a clearinghouse guarantee trades also may help bring the two markets closer together, said Sivan Mahadevan, a credit derivatives strategist at Morgan Stanley in New York. In the meantime, investors are pocketing the difference at a time when buying high-risk, high-yield corporate bonds with yields of 18 percent still means assuming the risk of default, which may rise to 15 percent by year-end, according to Moody’s Investors Service. High-yield, or junk, bonds are rated below BBB- at Standard & Poor’s and less than Baa3 by Moody’s. “For those situations where there’s a risk of some sort, you should probably be putting on basis trades,” Citigroup’s Foux said. To contact the reporter on this story: Shannon D. Harrington in New York at sharrington6@bloomberg.net