The sudden plunge in loan prices in March spooked banks. One multibillion-dollar hedge fund manager said the bank he uses put a hard stop on any more such trades because of worries about counterparty exposure in a volatile market.
Hintze, the founder of hedge fund CQS, saw bets in its $3 billion Directional Opportunities fund dive in a matter of weeks. One of the strategies at the fund, which is personally managed by Hintze, sells short-dated protection with credit-default swaps to investment banks on hundreds of investment-grade and high-yield bonds.
Generally, such trades work like so: The initial outlay for an investment fund is a mere fraction of the total outstanding notional value of the bonds being insured, resulting in implied leverage. If the bonds don’t default by the time the protection expires, the firm providing insurance comes out on top. But such bets can be undone by a relatively small number of defaults on the underlying debts.
CLOs
The drop in prices for leveraged loans is also hitting investment vehicles known as collateralized loan obligations that are packed full of them. The vehicles sell an equity slice and interest-paying bonds so they can buy up loans. But to get the deals off the ground, managers kick-start them with borrowing, typically drawing on a form of bank financing known as warehouse facilities. Goldman Sachs Group Inc. and JPMorgan Chase & Co. recently sent out demands to some managers of the deals to put up more cash against those warehouse lines after loan prices fell.
Within the tranches of securities sold by CLOs, the equity is the riskiest piece because it gets paid out only after the bondholders are paid in full. That essentially makes equity stakes another form of leveraged bet on the performance of the loans.
Read more: CLOs: Corporate Loans Sliced, Diced and Worrisome: QuickTake
Some investment funds have levered up their bets on securitized debts with bank financing. They might, for example, put up cash as collateral to gain the ability to spend several times that amount on debt, such as highly rated CLOs. In relatively safe pockets of structured credit like AAA-rated CLO paper, investors might borrow at seven times from banks to fund their trades.
Investors can also put up a high-quality asset to borrow cash through the repurchase agreement market, using it to then buy illiquid but higher-yielding assets. In either case, the borrowing of money can magnify returns. Yet if the assets start to lose value, banks can demand more money up front or force liquidations.
Banks now have much higher capital requirements than in 2008. That makes securitized products more onerous for many dealers to hold as collateral, which encourages banks to make margin calls.