The World Converges on Little Rock in Hunt for Returns

  • Windstream debt features in estimated $3.5 billion of trades
  • Turbocharged yields give new life to market left for dead

A strange thing happened to Windstream Holdings Inc. of Little Rock, Arkansas, as it struggled with declining revenue: it became a darling of credit investors all over the world.

The telecommunications company features in an estimated $3.5 billion of complex wagers -- known as synthetic CDOs -- that the global credit boom will keep America’s heavily indebted companies out of trouble for a while longer. Junk-rated Windstream, along with the magic of financial engineering, helped Wall Street turbocharge yields and breathe new life into an exotic investment that had been left for dead in the wreckage of the 2008 financial crisis.

Now, the company has emerged as a troubling omen as it tussles with a hedge fund that Windstream says is trying to push it into bankruptcy. After synthetic CDO bets sent the cost of insuring the company’s debt in the short-term toward historic low levels, Windstream’s sudden troubles are giving investors a flavor of how quickly their fortunes can turn.

“We have seen this movie before,” said Peter Tchir, a strategist at Academy Securities Inc. in New York, who has traded and advised on credit derivatives for over two decades. “Investors become convinced that while there might be risk, it is further in the future. It leaves the market susceptible to surprises.”

Having seized shut after the crisis, the market for synthetic CDOs has grown rapidly in recent years to roughly $70 billion. While sales have accelerated this year, it’s no where close to the hundreds of billions of dollars of deals that took place before the crisis.

Each trade uses derivatives known as credit-default swaps to insure against losses on the debt of as many as 100 companies. Other popular risky and high-yielding credits for CDOs include swaps referencing retailers J.C. Penney Co. and Staples Inc., according to a market participant with the knowledge of the deals.

Snow Chief

Swaps on the debt of Plano, Texas-based J.C. Penney are referenced by about $7 billion of synthetic deals, including a $700 million CDO BNP Paribas SA priced in July called “Snow Chief,” the person said. A spokeswoman for BNP declined to comment on the transaction.

Once the portfolio is decided upon, it’s then sliced into so-called tranches, with the riskiest pieces sometimes returning 20 percent or more, but facing a total wipe-out after losses on just 7 percent, or less, of the underlying portfolio. The safest pieces pay much less, at about 0.6 percent a year, but yields are often juiced by adding leverage.

Because the latest synthetic CDO trades have largely been limited to three years or less, the contracts are suppressing yields on shorter-term credit swaps, leaving CDO investors vulnerable to a sharp correction were sentiment to sour in the next few years.

That’s what happened with Windstream. During the first half of 2017, the resurgent CDO market pushed down the amount investors are paid for two-year Windstream credit swaps to about four percentage points less than what investors in a five-year swap would have been paid. During the previous decade, the gap was about two percentage points, meaning that two-year swaps investors earlier this year were getting paid about half the amount they would have received in previous years relative to the longer-term contracts.

Windstream Stress

Spreads have been similarly suppressed on other short-term swaps referenced in multiple CDOs including those on J.C. Penney and Staples.

By August everything had changed for Windstream. The cost of two-year swaps soared as the company missed analysts’ sales forecasts and halted its dividend amid customer losses and a declining landline business. S&P downgraded the company in September.

Also last month, Windstream said it received a letter from a bondholder, later identified by Bloomberg News as Aurelius Capital Management, who claimed the company’s spinoff of a unit amounted to a default on its debt.

Two-year swaps surged so much that the annual premium surpassed what investors buying five years of protection were paying -- an anomaly in the market known as an inverted curve. By the end of September, credit-swaps traders were demanding an annualized 25 percentage points to insure against a Windstream default for two years, a level that implied a 60 percent probability of default.

A spokesman for Windstream declined to comment on the firm’s inclusion in CDOs or the spreads on credit-default swaps referencing the company.

CDO Renaissance

CDOs are enjoying a renaissance because they can offer buyers yields that can be four times those available on U.S. junk bonds. Hedge funds are the main buyers of the riskiest portions of the debt, while some pension funds and endowments have become senior tranche investors.

Investors and rivals say Citigroup Inc. arranged more than half the deals that have come to market, with credit correlation trader Jia Chen helping establish the bank as the dominant player. A spokeswoman for Citigroup declined to comment on the bank’s role in the CDO market.

The mere suggestion of a revival of synthetic CDOs, which the U.S. government said “multiplied exponentially” the losses from the housing collapse, is enough to send shivers down the spines of those burnt in 2007 and 2008. However, this time the deals offer bets on the health of corporate America rather than subprime mortgage borrowers, and proponents of the recent deals say banks now face less risks because they offload all portions of the CDOs.

“A blow-up in the deals of the like seen in 2008 is unlikely unless we see a dramatic event like a recession triggered by a central bank policy error,” said Tracy Chen, the Philadelphia-based head of structured credit at Brandywine Global Investment Management, who has avoided the transactions. “Having said that, the increase of corporate leverage means the risk to investors is not zero.”

Swaps Ruling

CDO investors dodged a bullet last week when an industry body for the credit derivatives market, said Windstream’s transfer of assets to a unit in 2015 didn’t constitute a failure-to-pay credit event. Had the International Swaps & Derivatives Association’s determinations committee ruled otherwise, CDO investors would have borne losses.

That may not be the end of the matter though. A Delaware Chancery Court is yet to rule on whether Windstream has defaulted on $3 billion of bonds due to its spinoff of Uniti Group Inc.

The stakes are high for CDO investors because an estimated $350 million of Windstream credit swaps insuring its debt have been included in CDOs since 2015, according to the market participant familiar with the transactions. That’s almost two thirds of the net $550 million of outstanding credit swaps covering the firm’s debt as of Sept. 1, according to the latest data from ISDA.

While synthetic CDOs compressed credit spreads for some names beyond their fair values, that doesn’t mean the products have necessarily made moves in companies like Windstream any more violent than they would have been otherwise, said Brandon Kufrin, a portfolio manager at Cairn Capital in London who has invested in synthetic CDOs for the past six years.

Even so, wild swings in credit swaps are just too reminiscent of what happened the last time Wall Street’s CDO machine accelerated, according to Academy Securities’ Tchir.

“Just like in early 2007, when curves were very steep and it seemed as though everyone was a seller of credit protection, especially short dated protection - we saw how quickly that could reverse,” Tchir said.

— With assistance by Neil Denslow, and Katie Linsell

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