Investment Capitalist

Corporate bonds have been on a tear since April; however, the paper of financial firms has outperformed all other categories by a significant margin. This is odd and perhaps suggests the market is either not correctly pricing this paper, or something is artificially preserving their value. During April and May, investment-grade subordinated financial bonds returned an average of 18%. Certain subordinate notes from SunTrust, Capital One, Regions Financial, Fifth Third, and PNC have posted gains of 50% or more in May alone.

What the heck is going on? Have corporate bond investors lost their minds or could this be a short squeeze? More importantly to me, is there a play here on the equity side? Logic (and institutional schooling) would suggest buying the bonds and selling the stock short as a hedge against insolvency. But if you haven’t noticed already, logic and old-school rules no longer apply.

Subordinated paper has a strangely attractive risk/reward profile to pure-play equity traders. But to us Global Macro folk, the issue is quite obvious. In a bankruptcy, sub-note holders get wiped out. As the bankruptcies of WaMu and Chrysler have shown us, the rules no longer apply when taxpayer money is being used for a bailout. However, let’s assume the bank’s credit profile improves. Because we’re talking commercial paper, the upside is limited to par. Most of the weaker banks have sub notes trading at $50-$70 (i.e. vs. $100 par, upside is capped at 50%.). If the upside is a maximum of 50% while the downside is total loss, I’d argue that buyers of these notes are smoking something,

Why not buy the common where the upside is unlimited while the downside is 100% in names like FITB, KEY, RF, HBAN, etc…?

Now, what defines “systemically important”? KeyCorp and Fifth Third have $98 billion and $119 billion in assets, respectively. Just before being seized by regulators, WaMu had $310 billion in assets. Nonetheless, WaMu’s sub note holders were wiped out without even a toaster or coffee mug to show for their investment. Now, do you still think KEY and FITB will be “saved” by regulators in the event of insolvency and subsequent FDIC seizure? If you do, pass the doobie.

So, is the trade to short the paper and buy the common, or short the common and buy the paper? Or more perversely, buy the paper and the common and hedge with a CDS. Now you’re talking.

Oh, and did anyone even notice the government’s announcement on Friday that they were walking away from the Legacy Loans Program portion of the PPIP? What does that mean? In simple terms, the government has decided it has no desire to provide any form of capital relief for bad loans on bank books. But to add insult to injury, the government has also decreed that banks can’t sell these assets at “market-clearing” prices because they will become insolvent simultaneously. Duh! Hello? Didn’t we see this play out already with the downward spiral of Lehman and Bear? Does anyone still remember Long-Term Capital?