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Whale’s Trade in Comeback as Junk Fervor Fades: Credit Markets

Whale’s Trade in Comeback as Junk Fervor Fades
Pedestrians walk past the offices of JPMorgan Chase & Co., center left, in the business and financial district of Canary Wharf in London. Photographer: Simon Dawson/Bloomberg

Nine months after the JPMorgan Chase & Co. trader known as the London Whale amassed credit-derivatives bets that sparked $6 billion in losses for the bank, rivals from Bank of America Corp. to Morgan Stanley are recommending one of his main strategies.

Morgan Stanley analysts included among their top 13 trades for 2013 a bet that the cost of credit derivatives protecting against losses on junk bonds will get more expensive relative to investment-grade debt as sluggish growth fuels more corporate defaults. After the difference between the measures plunged to a 14-month low in September, Bank of America credit trader Kavi Gupta wrote in an e-mail to clients last month that the so-called decompression trade was his favorite strategy.

The wager was among those amassed by Bruno Iksil, the London-based trader whose positions were at the heart of the biggest U.S. bank’s losses. While a loser for Iksil, fired after what JPMorgan Chief Executive Officer Jamie Dimon called “flawed” and “poorly executed” positions, the strategy is now in fashion after Federal Reserve efforts to hold down interest rates and push investors into riskier assets drove junk-bond yields to a record-low 6.84 percent in October.

Whale’s Tail

“Everyone has the same position, everyone’s being pushed by the Fed into positions they don’t really like,” Stephen Antczak, Citigroup Inc.’s New York-based head of U.S. credit strategy, said in a telephone interview. “In a risk-off, high yield would be most susceptible.”

The cost to protect against losses on the Markit North American High Yield Index, linked to the debt of 100 speculative-grade companies from radio-station owner Clear Channel Communications Inc. to electronics retailer RadioShack Corp., has plunged 191 basis points this year to 490 basis points, Bloomberg prices show.

The gap between it and Markit Group Ltd.’s investment-grade index narrowed 161 in the four months after Dimon disclosed JPMorgan’s loss as the bank unwound Iksil’s trades, reaching 359 on Sept. 20, Bloomberg prices show. The difference has since been expanding, widening to 391 as of yesterday.

‘More Selective’

The increase in measures of junk-bond risk is poised to continue as investors faced with increasing default rates back away from the riskiest companies, said Cedric Lespiau, co-head of credit-index trading at Societe Generale SA in London.

“We see the market entering a phase where risk-managing is going to be much more selective,” said Lespiau said.

Elsewhere in credit markets, the cost of protecting corporate debt from default in the U.S. declined for a third day, reaching the lowest level in a month. The Markit CDX North American Investment Grade Index, which investors use to hedge against losses or to speculate on creditworthiness, decreased 1 basis point to a mid-price of 96.5 basis points as of 11:54 a.m. in New York, according to prices compiled by Bloomberg. That’s the lowest level on an intra-day basis since Nov. 7.

The measure typically falls as investor confidence improves and rises as it deteriorates. Credit-default swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

The U.S. two-year interest-rate swap spread, a measure of debt market stress, decreased 0.81 basis point to 10.94 basis points as of 11:53 a.m. in New York. The gauge narrows when investors favor assets such as company debentures and widens when they seek the perceived safety of government securities.

Too Early

Bonds of New York-based Citigroup are the most actively traded dollar-denominated corporate securities by dealers today, with 123 trades of $1 million or more as of 11:54 a.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

Increasing wagers that the junk-bond swaps index will diverge from investment-grade may show that Iksil’s trade last year, while not fundamentally wrong in the longer term, may have been a year early and doomed by its size.

The scope of Iksil’s trades, one of which swelled the outstanding net positions in an investment-grade swaps index by an unprecedented 67 percent, made it almost impossible for him to get out of his positions without exacerbating his losses, market participants said at the time.

‘Wrong’ Short

“The people doing it thought that they were maintaining a short against high-yield credit that would benefit the company in a crisis,” JPMorgan Chief Executive Officer Jamie Dimon said in June 13 testimony before the U.S. Senate Banking Committee. “We now know they were wrong.”

Kristin Lemkau, a spokeswoman for JPMorgan, declined to comment.

The difference between the junk-bond index and the investment-grade benchmark, which was 498 basis points the day Bloomberg News first reported Iksil’s trades were distorting credit derivatives markets, initially climbed to as wide as 585 after JPMorgan disclosed losses from the trades in May before plunging through September.

Bond buyers have been pushed into riskier assets as the Federal Reserve seeks to boost the economy by holding benchmark interest rates at zero to 0.25 percent for the past four years. Fed Chairman Ben S. Bernanke has been trying to spur U.S. economic growth by buying bonds and keeping interest rates at around zero until at least mid-2015.

Record Inflows

Investors have poured $452 billion of cash into fixed-income funds this year, already an annual record, according to Cambridge, Massachusetts-based EPFR Global. The 12-month speculative-grade default rate fell to 2.7 percent in November from 2.8 percent in October, S&P said Dec. 3.

The extra yield investors demand to hold investment-grade corporate bonds instead of similar-maturity government debt have tightened 97 basis points this year to 160 through yesterday, according to Bank of America Merrill Lynch index data. Spreads on speculative-grade debt have narrowed 175 to 548.

Junk-bond bears who “would have been bruised” this year on the decompression trade may still be waiting a while for a selloff to materialize, said Geoff Oltmans, managing director at Silver Lake Credit.

“This trade would have sounded attractive a year ago because you had the same view that high yield was expensive,” Oltmans said in a telephone interview. “At some point in time, you look like a hero doing this trade because we know with debt cycles there’s a period in time when high yield backs up. But trying to call when that will happen is very difficult.”

‘Fav Trade’

Credit traders are turning to the derivatives indexes because hedge funds and other investors often use those first to hedge against losses before selling the actual bonds.

The derivative indexes are “used by a lot of hedge funds as a macro hedge, so when there’s a risk-off sentiment, those spreads widen quite a bit,” Neil Chriss, founder of $1.1 billion hedge fund Hutchin Hill Capital LP, among the investors who had bet against Iksil earlier this year by taking the opposite side of his wagers, said in a Dec. 4 interview on Bloomberg Television’s “Market Makers.”

Bank of America’s Gupta wrote in a Nov. 29 e-mail to clients obtained by Bloomberg News that the decompression strategy “is my fav trade here.”

Speculative-grade debt will be “more vulnerable to fading corporate fundamentals, rising defaults and less attractive valuations,” Morgan Stanley strategists led by Sivan Mahadevan wrote in the group’s 2013 outlook for credit markets.

Almost 40 percent of speculative-grade companies tracked by Morgan Stanley reported negative year-over-year growth in earnings before interest, taxes, depreciation and amortization in the third quarter, according to analysts Adam Richmond and Jason Ng.

“The liquid CDX indices are the right way to position for a decompression between IG and HY at current levels,” the Morgan Stanley analysts wrote.

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