The HP Capital-Structure Arbitrage

[Anonymous]

The HP capital-structure arbitrage

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.

http://allthingsd.com/20120731/debt-markets-arent-only-worried-about-hp-but-dell-and-others-too/

Debt Markets Aren’t Only Worried About HP, but Dell and Others, Too

Last week I wandered a bit into the financial weeds to take notice of the fact that someone appears to be getting nervous about Hewlett-Packard and the prospects of its ability to make good on its long-term debts.

What tipped me off is the price of an obscure financial instrument known as a credit default swap. You may remember them from such hits as the great mortgage meltdown of 2008. While these credit default swaps have no connection whatsoever to mortgages, they do the same thing as the swaps did in that case: They serve as insurance.

When a lender worries about the likelihood that he’s going to get repaid, he can buy insurance against the chance that the borrower defaults. That’s essentially what a credit default swap is. You buy one, and if the borrower defaults, you get paid. If the borrower doesn’t default, whoever sells the swap pockets the fee, just like an insurance company. It’s a decent business, and there’s a thriving market for credit default swaps on all kinds of debts.

Anyway, last week I pulled some data showing that the price to buy this protection on HP’s debt has gone up — way up — since this time last year. In industry shorthand, the price to buy protection on $10 million worth of HP debt for five years has been “blowing out.” (Hence the movie poster from the forgettable 1981 John Travolta movie.) Protection a year ago that cost $65,000 has gone up to $325,000, while prices on the swaps covering debt on IBM and Oracle have stayed more or less flat.

And while it has no direct bearing on HP’s finances or operations — credit default swaps are derivative instruments — they do serve as an important barometer of the mood of bond markets that trade in debt. If the price to insure against the possibility of a default, however remote, is rising, the cost to take out new debt by issuing bonds can increase, as can the cost of refinancing existing debt. And when you consider that HP has a net debt burden of about $21 billion, a small increase in the costs associated with financing it can have a direct effect on operations.

Apparently I was on to something. It turns out that the “blow out” isn’t just happening to HP’s debt, but to debts held by Dell, Xerox and Lexmark, too. Today, The Wall Street Journal’s Rolfe Winkler looked at all three and saw similar pricing trends. The most extreme case was at printer maker Lexmark, where the cost of swaps on its debt have tripled to $590,000.

At a moment when other once-solid tech companies like Nokia and Eastman Kodak are in distress, more people are betting on — or insuring against — the possibility that HP, Dell, Xerox and Lexmark end up like them.

[Author]

August 2, 2012 at 8:47 AM