Cold Trade
Several hedge funds in Copenhagen have made hay in pursuing a spread trade involving Scandinavian covered bonds—mortgage-backed debt, which, unlike MBS, are of high quality and remain on issuing banks’ balance sheets with well-maintained loan-to-value ratios.  Bonds are double backstopped first by the banks and then by ring-fenced mortgage pools. Since they were invented more than 200 years ago, these bonds have never defaulted.

Michael Petry, head of Danske Capital’s Invest Hedge Fixed-Income Strategies, with nearly $1.5 billion under management and annualized returns of nearly 14% since it started in 2005, says the financial crisis created a special opportunity in this asset space that has lasted into 2014.

The trades are short in duration, typically playing out over six to 12 months. The fund rarely holds until maturity. Instead, it rotates exposure to maturities ranging from one to five years to capture the most attractive spreads versus short-term rates while hedging interest rates to protect against a move against the portfolio’s position.

The trades are premised on the belief that profits can be churned from relatively wide covered bond spreads and/or from the financing of three-legged trades involving swaps to hedge interest rate risk and repos to finance the trade.

This is how it works:
Danske Capital would establish a position, say in a liquid, five-year, AAA-rated Nordea Hypoteck bank-issued covered bond with a yield of 2.5%. The corresponding swap rate, which hedges the fund’s interest-rate exposure, cost the fund 2.1%. This netted a difference of about 40 basis points.

By participating in the swap, the fund would simultaneously receive a three-month floating payment of 0.93%. Using two-week-to-one-month repos to finance the trade costs the fund around 0.85%, or 8 basis points less than the floating swap payment. This leaves the fund with minor interest rate risk in the very short end of the curve—the maturity difference between the three-month fixed rate and the length of the repo.

So Danske Capital collects a total of 48 basis points a year.  It then applies leverage, which has added an average of 5 percentage points a year to the fund’s performance over the past six years.

If the cost of interest protection—or swap—rises, Petry believes the fund is protected by consistently rolling over this trade, reestablishing desirable spreads. This is normal given that the yield on covered bonds would likely rise at the same time. Likewise, if the cost of repo financing (which is secured by the bonds as collateral) were to rise, the floating rate payment the fund receives would likely rise even further. 

As with the above-mentioned Italian bond trade, there’s no currency risk because any shifts in currency value are naturally hedged by the use of repo financing.

The fund took an initial hit when it first established these trades as market dislocation caused sharp fluctuations in covered bond prices and financing. But since 2009, it’s been a reliable source of performance. The fund has begun unwinding these trades as spreads have significantly narrowed.

The credit shop Whitebox Advisors in Minneapolis specializes in identifying mispriced pieces in distressed companies’ capital structures. Since its Credit Arbitrage Fund started in 2002, this strategy has generated annualized returns of 15.76%.

Senior portfolio manager Peter Wiley says his team saw in 2010 that the market was divided in its response to financial turmoil surrounding the East Coast supermarket chain A&P.

Early that year, as the company’s financing was worsening, a $260 million second-lien bond with a 11.375% coupon due in 2015 sold off sharply on fears that the potential issuance of new debt would be superior in order of protection to the existing issue.

Meanwhile, some investors saw the potential new bond issue as a way to refinance the firm’s $255 million, 6.75% convertible bond, which was maturing in two years. Accordingly, its value held up much better, despite being lower in the capital structure than the second-lien bond.

Though the fund was reticent on trade price and timing specifics, Wiley said that the greater sell-off of the second-lien bonds significantly compressed the spread and mispriced risk. His team’s credit research felt that even if bankruptcy occurred, the second-lien bonds, which were fully collateralized, would likely be paid off at par. At the same time, bankruptcy would wipe out the convertible.