In the weeks after the September 15 bankruptcy of New York investment bank Lehman Brothers Holdings, Chicago hedge fund firm Citadel Investment Group sustained stunning losses. So dire was the situation at Citadel — whose funds were down nearly 50 percent on the year through November — that CEO Kenneth Griffin held a special conference call for bondholders (unique among hedge fund firms, Citadel had issued public debt). As nervous creditors listened in, Gerald Beeson, COO of the $13 billion firm, said that much of the damage incurred was from “the unprecedented dislocation of the price of cash assets relative to the price of derivative securities.”
It was an arcane but telltale clue as to what was at the heart of Citadel’s problems. The firm had been using credit default swaps to hedge positions in — among other things — high-yield and investment-grade bonds. Directly and indirectly, the firm was invested in what is known as the negative-basis trade. Citadel took large, leveraged stakes in corporate bonds and simultaneously bought credit default swaps as insurance. To finance the position, it borrowed against both the cash bonds and the CDSs. After Lehman filed for bankruptcy, the value of the bonds dropped sharply, leaving Citadel with credit losses not covered by the swap contracts, which would kick in only if the bond defaulted. In addition, concerns that counterparties would go bust and not be able to make good on their obligations caused a steep rise in CDS haircuts (the discount a lender puts on the value of a swap). Citadel was forced to refinance some positions at a higher cost and get out of others at a loss.
In credit markets, the profit potential from a negative-basis position like the one Citadel pursued exists when the spread on a bond is greater than that on the corresponding CDS — meaning that the CDS is showing less likelihood of default than the underlying bond. The payout from the bond finances the derivative position — providing, in effect, a free hedge. For example: As of October 31, the credit spread on a Starwood Hotels & Resorts Worldwide note was 1,078 basis points; the spread on the corresponding CDS was 544. A trader could buy the bond, use the yield to pay for the insurance and pocket the difference.
In a typical market, bonds and their corresponding derivatives trade closely with one another. There isn’t much opportunity for the negative-basis trade, and where it does exist, the spread tends to be narrow — hence the use of leverage. But in 2008 the relationship between cash bonds and derivatives was blown apart by market volatility, the growing subprime crisis, the seizing up of credit, rising counterparty risk and the sell-off in bonds.
Other big firms that used the strategy included $3.1 billion credit specialist BlueMountain Capital Management and $5 billion Aladdin Capital Management. “Funds were betting on a return to normalcy,” says Brian Yelvington, a senior macro strategist with research firm CreditSights. “And instead of stabilizing or getting better, the state of the credit markets worsened.”
A few firms — including Citadel — have recently been doing the negative-basis trade with little or no leverage and making money. But with the credit markets still in tatters, the ability to use leverage is still a long way off.
