Think credit default swaps are just the domain of an exclusive set of New York and London hedge funds? Think again. CDS have even entered Newport Beach, California in the public discourse of one of the largest bond mutual fund companies: Pimco.
And we are not even talking about simple buys or sells but also more calculated strategies like negative basis trades. Bloomberg previously highlighted the recent widening spread between CDS and cash bonds which has caused Pimco to partake more in negative basis opportunities trades.
Gaps between credit-default swaps and bonds have widened to 0.25 percentage point from less than 0.02 percentage point about three months ago, according to Citigroup Inc. Pimco, manager of the world’s largest bond fund, is finding as much as 1 percentage point of extra yield even after paying to insure bank debt, said Mark Kiesel, a managing director at the Newport Beach, California-based firm.
Banks are “rebuilding capital very quickly,” Kiesel said. With the firms becoming safer credit bets and Pimco finding so- called negative basis trades with bank bonds paying excess yields of 0.8 percentage point to 1 percentage point, “those are two catalysts for spread compression,” he said…
The spreads Pimco is identifying in bank bonds and in the broader market compare with the average difference of more than 2.5 percentage points after the bankruptcy of Lehman Brothers Holdings Inc. two years ago, just before bonds posted a record rally. The record gaps emerged as credit markets seized up, causing bond spreads to soar while demand for swap protection failed to keep up….
An increase in negative basis is attracting buyers that seek to profit by buying the debt while also purchasing credit swaps.
“When capital is scarce, the basis becomes more negative,” said Alberto Gallo, a New York-based strategist at Goldman Sachs Group Inc. He said the basis should narrow as monetary policy and regulation reduce risk in the financial system and stabilize funding costs.
Sample Postitions
So exactly what kind of positions has Pimco been buying? Well since mutual funds usually only report their performance on a quarterly basis, it will be hard to tell exactly what bank positions the fund has newly entered into in the excerpt from above but since Pimco’s use of CDS is not a new or recent one, it is possible to see what kind of swaps the company has liked enough to buy (or sell) in previous quarters (i.e. first-half of 2010 and before). According to holdings reports on several of Pimco’s mutual funds, they have quite an inventory of various swaps – both buys and sells.
For example, in Pimco’s nearly billion-dollar US$ Global Bond Fund (unhedged), they list a number of different swaps not just in US$ but in foreign currencies as well. Those include a $50 million position in the 10-year CDX North America Investment Grade Series 8 CDS index (an index of CDS referencing North American companies). It might also be interesting to note that the position is up almost $3 million (as of June 30, 2010). Other smaller positions include a $7 million CDS (buy) on Autozone, $2.7 million CDS (buy) on Computer Sciences Corp, $4 million CDS (buy) on Altria Philip Morris, £2.5 million CDS (buy) on WPP Group, €0.8 million CDS (buy) on Barclays Bank subordinated euro-debt, $5.1 million CDS (sell) on Australia government debt and over $15 million CDS (sell) on British government debt (latter two both being sovereign CDS).
In another fund, the Pimco High Yield Municipal Bond Fund, the holdings report lists 2 municipal bond positions: a $5 million CDS (sell) on the Long Island Power Authority and a $5 million CDS (sell) on the Puerto Rico Electric Power Authority. (On a side note, California’s most important financial company appears to be embracing municipal CDS while its home state would ideally like to ban them)
If those are not enough swaps to read through, have a look through the $9 billion Pimco High Yield Bond Fund. Naturally being a much larger fund, it also holds some much larger positions including: a $40 million CDS (sell) on Ally Financial, a $30 million CDS (sell) on El Paso senior debt, a $25 million CDS (sell) on Community Health Systems senior debt and a $52 million CDS (sell) on the CDX North American High Yield Series 9 25%-35% index tranche. [Note CDS index tranche trading is a more advanced tool which allows investors to trade correlation using specific attachment and detachment points, in this case exposure to losses in excess of 25% but under 35% in the index. Interested readers can have a brief look here or a little more detailed look here].
The Pimco High Yield Fund also had about $137 million in sovereign CDS sold against Brazilian ($30 million), Indonesian ($37 million) and Mexican ($70 million) government debt which matured on September 20, 2010 (and as neither country missed a bond payment over that time, those positions would have returned a handsome profit for holders of the fund).