Markets

Lisa Abramowicz is a Bloomberg Gadfly columnist covering the debt markets. She has written about debt markets for Bloomberg News since 2010.

Congratulations to one of 2016’s most successful traders: Tom Malafronte of Goldman Sachs.

This New York-based junk-bond trader generated about $250 million in revenue this year through the start of October, according to a Bloomberg News article on Tuesday by Dakin Campbell and Sridhar Natarajan. That's a lot of money for any trader but especially one at a Wall Street bank that limits traders' risk-taking.

How did he do it? Malafronte began buying beaten-up bonds in January, taking risks on mining companies such as Freeport-McMoran and Teck Resources as well as troubled retailers such as Toys "R" Us and Gymboree Corp., according to the Wall Street Journal in October. He held onto some positions for just hours, some for weeks.

Massive Recovery
Bonds of Teck Resources, a mining company, have more than doubled in value since their lows this year
Source: Bloomberg

Of course, his huge profit raised many eyebrows, even within Goldman. After closely examining Malafronte’s trades, compliance officers found that everything was satisfactory. They rebuffed the idea that Malafronte’s activities violated the so-called Volcker Rule, which was crafted as part of the 2010 Dodd-Frank Act to prevent banks from speculating with their own money.

Still, a big question remains: How does a trader clearly follow these new rules while crushing competitors and taking risks?

To answer that, let’s first look at the provisions of the rather fuzzy Volcker Rule, which generally prohibits proprietary trading but has an enormous caveat known as the underwriting and market-making exemption. Basically, Wall Street traders can buy and sell securities with their banks’ money as long as they can show that their activities ultimately helped facilitate trading more broadly among customers.

This brings us back to Malafronte. Without knowing for certain, here’s one theory of how he delivered huge gains while demonstrating he was doing so for the good of clients.

Earlier this year, energy junk bonds were trading at their lowest prices on record and the lowest-rated high-yield notes were sinking the most since the 2008 financial crisis. Some asset managers were liquidating their holdings because of client withdrawals.

At that point, several big asset managers, including Carlyle Group, Blackstone and Apollo Global Management, were starting to see good value in these bonds.

Let’s say Malafronte asked around, realized the scope of interest and then proceeded to buy these highly distressed bonds whenever he encountered them. He could then market the securities among the group of opportunistic buyers, seeing who was willing to offer the highest price.

He also possibly kept some for his trading account at Goldman Sachs given his understanding of how much demand there was for the notes. If someone questioned his motivation, he could simply say that he was warehousing the bonds for prospective clients. 

Energy junk bonds have gained more than 63 percent since their nadir in February, while the riskiest junk bonds generally have returned almost 45 percent.

Round Trip
The energy junk-bond market has recovered tens of billions of dollars in value since February
Source: Bloomberg

Specific bonds have gained even more, such as those of Teck Resources, which have gained more than 91 percent, according to Bank of America Merrill Lynch index data.

Big Bucks
Bond traders who wagered on certain distressed companies earlier this year won big returns
Source: The BofA Merrill Lynch US High Yield Index

All the while, it's easy to see how Malafronte could demonstrate he was working in his clients' interest to capitalize on opportunities and fostering trade in debt that was recently left for dead. Indeed, on some days Malafronte accounted for more than a third of all trading in some bonds, according to the Wall Street Journal article.

Malafronte will go down as one of the big winners of 2016. But in doing so, he disproved the myth of the neutered, Wall Street debt-trading desk in the wake of post-crisis regulations. While big banks aren’t harboring internal hedge funds anymore, they’re still able to take advantage of dislocations in credit markets. And that's before any potential rollbacks of new regulations.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Lisa Abramowicz in New York at labramowicz@bloomberg.net

To contact the editor responsible for this story:
Daniel Niemi at dniemi1@bloomberg.net