Hedge funds shopping for credit protection last week pushed default swap spreads on European names, such as France Telecom and Fiat, about 80 basis points wider apiece. The two names underperformed sector peers, such as British Telecom and DaimlerChysler, which each widened by only 20 bps.
Traders pointed to the disparity as a sign of heavy demand for protection from convertible arbitrage players. They said the demand came from hedge funds that had participated in the recent France Telecom and Fiat convertible deals but initially chose not to strip out the credit risk by purchasing a default swap because of a more-positive broader market. Now, however, with a bleaker outlook as rates appear headed upward and accounting questions hanging over the market, some investors are looking to buy credit protection. "The ones with convertibles out there are definitely the ones getting whacked more," said a trader.
Another trader noted that, particularly in the case of France Telecom, banks have their credit lines stretched thin because it has been an active borrower in the loan market. As a result, they are wary of selling protection, leading to a thin market and causing spreads to widen out quickly. Chris Francis, head of international credit research at Merrill Lynch, said buying default swap spreads are a good way for convertible arbitrage funds to strip out credit risk from convertibles they purchase. "So what you get is a lot of people buying protection and the basis widens out," he said, referring to the gap between synthetic and cash prices. As a result, he is recommending punters sell protection on Fiat rather than buy its cash bond.
