Capital structure arbitrage is likely to come back into fashion next year because of expectations companies will start to releverage their balance sheets. The hedge fund strategy fell out of favor in 2002 after some funds lost massive sums of money when the equity and credit markets defied the Merton model and moved out of whack with each other. "Credit versus equity relative-value is about to make a comeback," according to Viktor Hjort, analyst at Morgan Stanley in London. Luke Olson, head of convertible bond research at Barclays Capital in London, added, "It is definitely something people are looking at."
Strategists and hedge fund managers agree, however, that this time around traders will not be punting purely on an arbitrage, but will instead be using the theories to leverage their directional positions. George Hanjinicolaou, founder of New York-based Etolian Capital, said, "Models are simplifications of real life and if we blindly rely on them they will blow up in our face."
Capital structure arbitrage works by viewing equity investments as being long a call and treating debt investments as being short a put. Although most practitioners agree with the basic premise, real life is more complicated. The multitude of different credit instruments a company issues means it is not a pure arbitrage.
Matt King, head of quantitative credit strategy at Citigroup in London, said because of imperfections in capital structure arbitrage modeling it works best when the fund has a view on how the leverage of a company will alter. This is because one of the hardest elements of these trades is getting the right leverage on the equity and debt legs to profit, but when the company either leverages or deleverages its balance sheet the credit and equity markets move in opposite directions so the hedge ratio becomes less important.
Morgan Stanley's Hjort thinks many companies will issue debt to buy back shares, which will cause their credit spreads to widen and their share price to rally. He added this move is partly driven by corporates' attempts to wade off hostile leveraged-buyouts. According to Hjort the most efficient rating for a corporate--in terms of the weighted average cost of capital--is BBB plus or BBB, but because of the jump in costs if it slips below that level many corporates will aim for a single A rating. He lists GKN, Whitbread and Dixons as being potential LBO candidates and therefore ripe for capital structure arbitrage funds.
In addition, Hjort lists France Telecom, DaimlerChrysler and E.ON as corporates which might launch buyback programs.
King also sees a gradual shift in corporates raising debt and buying back shares but cautions the shift is moving remarkably slowly and many companies are still improving their balance sheet. In addition, many cross-over companies, which are the preferred targets because the fund needs lower multiples of debt versus equity in order to capture the spread, are still in the balance sheet repair phase.
One of the problems keeping some hedge funds out is the low volatility in equity markets. One manager said the strategy involves purchasing equity calls and in this environment a further drop in implied volatility could wipe out any profit from the capital structure trade.
