WSJ Deal Journal: Basis Trade ( Bond + Credit Default Swap)

May 4, 2009, 1:30 AM ET

The Brighter Side of ‘Evil’ Credit-Default Swaps
By Heidi N. Moore

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.

Safeguard Your Retirement (Motley Fool) - don't be tempted to chase hi risk investments

The Motley Fool

Don't Make This Life-Changing Mistake

http://www.fool.com/retirement/general/2009/05/01/dont-make-this-life-changing-mistake.aspx

Dan Caplinger
May 1, 2009

With the economy struggling, promises of financial security look especially attractive right now. But now more than ever, you have to look at such promises with a skeptical eye -- before you make an irreversible mistake that could ruin the rest of your life.

Unfortunately, it isn't too hard to find disreputable professionals who are willing to go to great lengths to take advantage of people's lack of financial expertise. Although the Bernie Madoff Ponzi scheme case is an extreme example, less dramatic situations can cause just as much damage to unsuspecting investors.

Unreasonable expectations
One common way that unscrupulous advisors trick people is by using numbers that are simply too good to be true. For instance, the Financial Industry Regulatory Authority (FINRA) recently imposed a fine of over $7 million on Morgan Stanley (NYSE: MS). FINRA alleged that Morgan Stanley brokers in upstate New York targeted workers at Xerox (NYSE: XRX) and Eastman Kodak (NYSE: EK), recommending that they take early retirement and allegedly promising safe annual returns of 10% or more to finance living expense withdrawals that wouldn't require them to dip into principal. Of course, when the bear market came, they lost huge amounts of their life savings.

You might wonder how someone might get duped into believing that they could count on double-digit returns with no risk. Historically, going after such high returns would generally force you to put almost all your money into stocks -- something that's far riskier than most new retirees would ever want to do.

Desperate times, desperate measures
Yet to understand how someone could get tricked like this, consider the lack of investing background that many people have. If you're a long-time worker at a company that has a traditional pension plan, you may never have had to manage your retirement savings at all. Yet you might be tempted by the opportunity to take a lump-sum withdrawal at retirement -- especially with incentives for workers to take early retirement packages, such as severance payments or other perks to sweeten the deal.

And with big employers like General Motors (NYSE: GM) and Ford (NYSE: F) struggling to survive a tough auto market, you can imagine that their workers wouldn't need much enticement to take an early-retirement package. Those workers would be especially vulnerable to puffed-up claims from financial advisors, especially if those claims allowed workers to do what they already believed was their best option in a bad situation.

Protect yourself
The majority of financial professionals do their best for their clients. But given the rash of abuses lately, you won't offend anyone by taking some steps to verify any advice you get from an advisor. Here are some things to keep in mind:

* Watch out for historical returns. Because the stock market as a whole has performed so badly even when you look back 10 years or more, you're likely to see return projections that are either based on longer periods or taken from certain periods. If you see an optimistic return projection on an investment, make sure you find out how it has performed during the bear market -- and in the years preceding it.
* Know your time horizon. To invest in stocks, you should expect to hold onto your shares for a relatively long time -- 5-10 years is a good range -- before you need the money. If you expect to use it before that, you shouldn't invest in stocks, even if they might give you better returns. You can't afford the risk of an ill-timed downturn.
* Don't swing for the fences. As a new retiree, the lump-sum payment you just got may be the last money you ever get from your former employer. So if you're considering individual stocks with part of that money, you should stick with relatively conservative companies like Microsoft (Nasdaq: MSFT) and Johnson & Johnson (NYSE: JNJ). Don't bet your life savings on a stock tip, no matter how attractive it may sound.

Plenty of intelligent people have been taken advantage of by convincing pitches from people who turned out to be crooks. If you're careful, though, you don't have to become the next victim.


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