Company debt costs may rise as popular trade sours

By Karen Brettell - Analysis

NEW YORK (Reuters) - U.S. companies, already facing exorbitant costs to sell debt, may find themselves paying even more as banks and other investors pull back from a popular strategy that had boosted demand for corporate debt.

Purchasing bonds and simultaneously buying protection on a company with credit default swaps has been popular, as in some cases it allows investors to generate premiums while taking no risk.

"Over the last six months corporate issuance was still getting done," said Brian Yelvington, analyst at CreditSights in New York. "If you could provide a large enough negative basis then the basis players would play in your bonds, and that was how some issuers were able to get the deal done."

Negative basis is when the cost of insurance is cheaper than premiums earned on the bond, the opposite of what is viewed as the correct relationship between the securities.

When the basis between a company's bonds and default swaps turns negative, investors, such as banks and some hedge funds, are lured into the trades by generous premiums for no credit risk.

For example, IBM Corp sold $1.4 billion in five-year bonds on October 10, which generated returns of around 2.65 percent, based on its Z-spread.

An investor buying default insurance on the company that day, meanwhile, would have paid only 87.72 basis points in the credit default swap market, according to data by Markit.

That means the investor would be paid around 177 basis points per annum from the trade, or earn $177,000 per $10 million in bonds, and have no risk on IBM's credit quality.

The trades would also profit if the relationship between the bond and credit default swaps reverts to a positive basis, which most expect will happen eventually.

LOSSES, UNWINDS

Instead of returning to a positive relationship, however, the basis on many companies has moved even more negative in recent weeks. This has created large losses in the market value of the trades, leading many to be unwound, which in turn is pressuring corporate bond spreads even more.

"In general, cash has vastly underperformed CDS in recent months," said Simon Moore, credit strategist at Credit Suisse in New York.

Fears over billions of dollars in debt that needs to be refinanced has caused corporate bonds to underperform. When bonds have been sold, they are also pricing wider than existing bonds, which in turn sends spreads even wider across the board.

"Some basis players got blown out of the water," Moore said. "Some trades, for example, may have originally had a negative basis of 100 basis points and now have widened to 300 basis points or more. When you're levered, that hurts a lot."

Tim Backshall, analyst at Credit Derivatives Research, noted earlier this week there was a lot of unwinding activity.