Thursday, October 25, 2012

Some hedge funds willing to blindly bet in debt market's darkest corners

Bloomberg ran an excellent article on how some hedge funds are willing to blindly bet and buy opaque debt securities.

Their recent experience with these securities reminds me of the old Wall Street story of an investor who tells the investor's broker to buy a stock, sees the stock go up, and then tells the broker to buy more.  Finally, after the stock price has doubled, the pleased investor tells the broker to sell.  The broker asks "to whom?"

If I was an investor in these hedge funds, I would not be compensating management until the positions have been sold.

BlueMountain Capital Management LLC and Saba Capital Management LP are leading investors into the debt market’s darker corners to boost returns, buying securities from collateralized loan obligations to bonds that seldom trade. 
BlueMountain, the $11 billion hedge fund firm in New York, raised twice the amount it anticipated this month from pension managers for a credit fund that buys CLOs, asset-backed securities and less liquid corporate bonds. 
Saba, founded by Boaz Weinstein, says CLOs are cheap compared with the underlying loans, while Citigroup Inc. sees banks “getting increasingly involved” in the securities for higher returns on capital....
Current disclosure practices for these securities makes it impossible for a buyer of these securities to know what they own.

The only way to know how the underlying collateral is currently performing is if the security provides observable event based reporting on each activity like a payment or delinquency involving the underlying collateral and reporting this activity before the beginning of the next business day.

Without observable event based reporting, hedge fund managers are simply guessing at what the value of the underlying assets might be.
“Some CLOs issued before 2008 are still undervalued comparing to the underlying assets,” James Wang, a money manager at Saba in New York, said in a telephone interview. Wang said he likes debt from older CLOs, which “are more stable because they are short-dated” and “have relatively low volatility compared to the average CLO.”... 
“We actually don’t think you have to take on that much more risk to enhance your return,” Bryce Markus, a money manager at BlueMountain, said in a telephone interview yesterday. “You need to forego liquidity and possibly accept complexity but not necessarily greater market risk. For longer- duration capital we think these types of assets make a ton of sense.”...
 Wasn't this argument made about sub-prime mortgage-backed bonds in 2007?
The move back into structured credit is likely to be tempered by the outsized losses they left investors with during the crisis four years ago, said Noel Hebert, chief investment officer at Bethlehem, Pennsylvania-based Concannon Wealth Management LLC, which oversees about $250 million. 
Institutional investors “won’t soon wade back into that pool regardless of yield -- too much career risk,” he said. “The one unforgivable sin is to get pinged by them again,” so it’s more hedge funds or more aggressive fund managers that are investing now, he said.
Actually, with the publication of the NAIC white paper that linked the capital insurers have to hold to the adequacy of disclosure made by the security, the aggressive fund managers are also taking on legal risk.

How do they explain to their investors that they are blindly betting when buying these securities?  If they don't tell their investors, are they setting themselves up to make the investors whole if the securities lose money?

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