Credit-default swaps have been demonized as having played a role in the struggles of insurer American International Group and in the collapse of Bear Stearns.
But these derivatives can be a force for good. Indeed, demand for credit-default swaps is among the factors spurring the revival in the market for corporate bonds. Large institutional investors, hedge funds in particular, are buying more investment-grade and high-yield corporate bonds of late and are pairing them with credit-default swaps to earn extra return, according to investment bankers.
The bond-swap combinations are called "basis packages," though they aren't sold together. The name refers to "basis trades," a common way for investors to take advantage of the price differences between a derivative and the underlying security. In the current iteration, an investment bank sells bonds on behalf of a company and the buyers then buy swaps tied to the bonds. In the past month, this investment strategy has helped spur demand for bond offerings from Lenar, Supervalu and Toll Brothers.
Credit-default swaps are a kind of insurance policy against issuers defaulting on their debt. In the past few years, hedge funds bought swaps largely to bet a company might default, and then bought the underlying bonds because they needed to pair the so-called short (swaps) and long (bond) positions. Now, hedge funds want the bonds and are buying the swaps to juice their returns and pair the trade.
It can be a profitable strategy in volatile markets, which is one reason bankers say it has picked up steam in the past month.
Here is how the math can work: A hedge fund buys a company bond trading at 50 cents on the dollar and a swap tied to the debt at, say, 80 cents on the dollar. If the issuer defaults and the debtholders get, say, 30 cents on the dollar in a recovery, the hedge fund would have a loss of 20 cents on the dollar for the bonds but a return of 50 cents on the dollar on the swap.
Such basis packages drove hedge-fund interest in recent high-yield deals, such as Supervalu's $1 billion offering on April 30, according to people familiar with the deal. Supervalu originally intended to sell only $500 million of bonds, but hedge funds looking to fill basis packages doubled the demand. These people say it was sold to 200 institutional investors. In fact, the Supervalu offering was spurred by what investment bankers call "reverse inquiry," which means buyers actually approached the investment banks -- Credit Suisse Group, Bank of America Merrill Lynch, Citigroup and Royal Bank of Scotland Group -- seeking out a deal.
The strategy poses risks if investors have to sell positions to meet margin calls for the bonds or the swaps before either brings a return.
Credit-default swaps may not yet have a sparkling-clean reputation -- but for many investors that is a secondary concern, since sitting around on piles of cash is no way for a hedge fund to live
