Hedge funds looking to trigger payouts on derivatives tied to Credit Suisse Group AG are clashing with investors that piled into a different hot trade.
The hedge funds have piled into a longshot wager that a derivatives industry panel will determine that the shotgun takeover of Credit Suisse by rival UBS Group AG was effectively the equivalent of a default event. Such a ruling would hand them a windfall score on their derivative positions, but the panel has already decided against the group once.
If the hedge funds succeed, another set of money managers stand to lose out. They’ve bet that Credit Suisse’s credit quality will converge with that of its rescuer’s as UBS essentially assumes its competitor’s obligations.
Money managers planning for this event would often sell credit default swaps on Credit Suisse’s junior debt, earning relatively high premium, while buying protection on UBS’s subordinated obligations, paying a relatively low premium. When the two banks formally combine later this year, the swaps contracts of both banks would effectively converge, allowing those that had made a succession trade to essentially close their positions and pocket the price difference.
At least some Wall Street analysts see this trade as likely to be profitable for investors.
“There’s never a zero risk trade but as far as we see a succession event is likely to happen, barring any merger risks,” Saul Doctor, a strategist at JPMorgan Chase & Co said in a phone interview. “Therefore selling CS CDS and buying UBS CDS has been an attractive proposition and a popular trade of late, and if you look at the trading volumes since early May you can see it’s been active.”
The gross notional volume for Credit Suisse credit derivatives as of May 5 amounted to $19.6 billion, from $17.9 billion on Feb. 24, according to data from the Depository Trust & Clearing Corporation.
Funds including FourSixThree Capital and Diameter Capital Partners had bought credit default swaps linked to junior Credit Suisse bonds, in a bet that a derivatives panel will rule that a credit event has occurred.
The panel on Wednesday ruled that one type of event that could trigger payment on derivatives, known as a government intervention event, hadn’t occurred. But the Credit Derivatives Determinations Committee has received another query asking if there was a bankruptcy event, which would also trigger payment on the instruments.
Credit Suisse’s swaps Group tumbled following Wednesday’s decision and continued to fall after the second question was asked Thursday, an indication that the market is not pricing in a near term payout on the swaps. The one-year subordinated contracts were indicated at 227.7 basis points at 9:58 a.m. London, from 887.7 basis points earlier this week, according to ICE Services data.
The same panel would also rule on whether a succession has taken place once the merger has closed and Credit Suisse’s debt has been transferred.
“Sometime after the acquisition the debt will move and it is at this point that the Succession would occur,” strategists at JPMorgan wrote in a note to clients.
--With assistance from Luca Casiraghi.
(Updates with attributions in sixth paragraph, pricing in tenth paragraph)
