The HP capital-structure arbitrage

By Felix Salmon
August 1, 2012
Arik Hesseldahl -- a tech writer who's the first to admit he's no expert on finance -- discovered the wonderful world of credit default swaps in general, and single-name CDS on Hewlett-Packard, in particular.

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Last week, Arik Hesseldahl — a tech writer who’s the first to admit he’s no expert on finance — discovered the wonderful world of credit default swaps in general, and single-name CDS on Hewlett-Packard, in particular. The cost of single-name protection on HP has been going up, and that can only mean one thing: it’s “mainly a barometer of the state of anxiety over its finances and its balance sheet”, he wrote.

Hesseldahl’s corporate cousins Rolfe Winkler and Matt Wirz followed up a couple of days ago:

A $10 million five-year insurance policy on H-P debt costs $260,000 according to data provider Markit. That price has doubled since April and quadrupled since a year ago. While there is no prospect of H-P going under any time soon, bond investors are clearly unhappy about the company’s deteriorating prospects and balance sheet.

But I don’t buy it. For one thing, as David Merkel points out in a comment on on Hesseldahl’s latest post, the HP bond market is not panicking at all: its bond prices remain perfectly healthy. He continues:

The markets for single name CDS are thin because there are no natural counterparties that want to nakedly go long credit risk. Those wanting to nakedly short credit risk therefore have to pay a premium to do so, usually higher than the credit spread inherent on a corporate bond of the same maturity.

And if one or two hedge funds want to do it “in size,” guess what? The CDS market will back off considerably, and make them pay through the nose.

It’s hard to spook the bond market for a liquid bond issuer; it is easy to spook the CDS market.

Why might one or two hedge funds suddenly want to buy protection on HP (and Dell, and Lexmark)? There’s an easy and obvious explanation: their share prices. HP, Dell, and Lexmark are all trading at less than 7 times earnings, at the lowest prices they’ve seen in a decade. They’re all in the fast-changing and volatile technology business. The only certainty here is uncertainty: it’s reasonable to assume that in five years’ time, each of these companies is going to be in a very different place to where it is now.

Which sets up an easy and obvious capital-structure arbitrage. You go long the stock, and then you hedge with single-name credit protection — the only way you can effectively go short the debt. The stock market is deep and liquid enough that you can buy your shares without moving the market; the single-name CDS market isn’t, but no mind. Even if you overpay a bit for the CDS, the trade still looks attractive, on a five-year time horizon.

In five years’ time, it’s entirely possible that at least one of these companies will be toast — in which case anybody who bought the CDS today will have scored a home run. On the other hand, if they’re not toast, the stocks are likely to be significantly higher than they are right now. Basically, the stock price is incorporating a significant probability of collapse, and if you take that probability away, then it should be much higher. And buying protection in the CDS market is one way of effectively taking that probability away.

This kind of trade only works for companies in unpredictable sectors that have low stock prices and relatively low borrowing costs; such opportunities don’t come along very often. But when they do come along, it’s entirely predictable that a hedge fund or two will put on this kind of trade. In no way are such trades a sign that bond investors are worried about the company’s future: in fact, bond investors are not the kind of investors who put on this trade at all.

And so, as Merkel says, reporters should be very wary indeed of drawing too many conclusions from movements in the illiquid CDS market. Sometimes, they really don’t mean anything at all.

Comments
9 comments so far

Thanks for the note that gives us insight into the ways that our financial system works.

My question is this: How does this hedging/CDS help the real economy? What value has this financial transaction added to the economy?

The way i see it, the financial market is siphoning off a lot of money in the name of market making and this upward movement of money without creating any value and based on arbitrage is the bane of the current global stagnation or liquidity trap as Paul Krugman calls it.

It is shocking that governments are not ready to step in and call for a roll back in CDS and other synthetic financial instruments even after the disaster of 2008. What a shame!

Posted by InfiniteThought | Report as abusive

I’d like to see the model that allows the stock price to plummet when there is a risk of future collapse, but leaves the bond price unaffected. Do they expect equity owners to get wiped out, but bond holders to remain whole?

There’s a step missing from your logic. I’m not saying it isn’t there (e.g. if HP pays no dividends, money might be flowing into the bonds instead of the stock), but your theory doesn’t explain the bond yields.

Posted by AngryInCali | Report as abusive

@AngryInCali, it may be a bet that the bond market is irrationally underpricing the risk while the stock market is irrationally overpricing the risk. Either bet alone (long stock, short bond) would be risky but profitable on average. Combining the two gives you a less risky trade that remains similarly profitable on average.

Posted by TFF | Report as abusive

As has been revealed over the past half-decade, the vast majority of this arbitrage does nothing, zilch, zip, nada, for the economy. It is simply Vegas-style betting, not tied to anything useful to the economy other than the potential of winning or losing a bet.

Posted by sagreer70 | Report as abusive

Bloomberg.com has the HP 5Y credit default swap price available for the public to see http://www.bloomberg.com/quote/CHWP1U5:I ND/chart. It went from 100 to 300bps (1% to 3%) so far in 2012. You can also find the notional value outstanding on the DTCC’s website somewhere http://www.dtcc.com/. All of these swaps referencing public company securities should be on public exchanges w/ price and open interest (notional values) available for the public to trade or at least watch. The equity options market is available on discount brokerages and has data on Google and Yahoo Finance. So, why isn’t there an active exchange traded mini-bond market with options to hedge?

Posted by dvolatility | Report as abusive

@dvolatility, doesn’t a CDS depend on knowing/trusting your counterparty? Hard to have an active exchange when you have a dozen different counterparties writing coverage on the same security.

Posted by TFF | Report as abusive

@TFF credit default swaps are to credit as options are to equities. Right?

Posted by dvolatility | Report as abusive

@TFF Isn’t that point of having margin calls?

Reuters has HP options trading right here. http://www.reuters.com/finance/stocks/op tion?symbol=HPQ.N&expDate=11/2012

For example, there are 24,000 Nov 17 puts open. Like CDS players, that probably involved a large buyer and seller of put insurance that has the option to sell a couple million shares at $17 if the stock was in the $ by Nov, right? Or sell the insurance to someone else. That seems like real money, and it’s a transparent, more liquid market that is available to anyone. There are even 6,606 $18 puts and 2,944 $15 puts open that expire in January 2014 http://www.reuters.com/finance/stocks/op tion?symbol=HPQ.N&expDate=1/2014

Someone could buy or sell 1 put tied to 100 shares but can’t do that with CDS referencing bonds. Or be able to do what this post says. By the way, these funds were doing arbitrage with synthetic MBS CDOs and were mispricing risk. Seeing some CDS rates (spreads) online is a move in the right direction. My most popular blog post has been links to CDS, which shows how opaque this market is and that people are interested. You see options blogs all around the internet analyzing stock and option activity. The same should be done with bonds and bond options or CDS volatility. I don’t understand why bond and CDS notional values aren’t cut down (par value). It seems like all of those unsecured exchange traded GM mini-bonds could have had an active insurance market of some sort.

Posted by dvolatility | Report as abusive

Yeah, I think you are right. Might need to update regulation to handle CDS, though. They aren’t quite congruous to options.

Posted by TFF | Report as abusive
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