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Noviembre 12, 2008 Trading/Arbitraging Bond Recovery Values
Why a bond recovery value is important? How can we arbitrage it? Let´s make sense of the importance of recovery values and therefore how to make money out of them. We will look at a specific trading example: General Motors.
Within fixed income markets everyone is more or less aware of the basics: bond price, bond yields, duration, convexity and, if we are lucky credit spreads, correlation or probabilities of default but... there is one part missing that does it! : Recovery Value. Let´s make a long story short: Recovery value is what you get as a bondholder when the issuer goes into bankruptcy. It is highly important because you can recover almost everything or almost nothing! How do we calculate it?
Some people think that we evaluate the assets and liabilities at market value. But that´s not the case. The standard procedure is to use the bond price aproximately one month after default. That´s why we know already that Lehman Brothers has a recovery value of circa 9%, because that has been the average of the bond price recently. It would be impossible to analyse Lehman asset/liabilities that soon. Typical recovery values ranges from 0%-20% (Technology, Telecoms, Biotech,... and Investment Banks loaded of subprime...), 20%-40% average corporate companies (Electrical Utilities excluding.... Enron!) or, even higher than for firms with a large base of fixed assets like a railway company (Railtrack, the UK trains network company defaulted with a high recovery of circa 75%). I remember top of my head that Lehman defaulted with circa 9%, Enron had around 10% and Parmalat 10% recovery values... Icelandic Banks defaulted with a recovery value which was close to zero, zip, nothing! As a rule of thumb rating agencies use 30%/40% for senior debt and 10% for subordinated debt.Why would the do this? Because they need to make an assumption in order to be able to price up CDOs.... By the way ... the so called "Digital recovery CDOs" have their recovery values fixed in advance... So you do not need to be concerned about them. You know for a fact that if IBM defaults, they wil do so with a 30% pre-fixed recovery value. This is very nice... but... how can we make money out of it... Let me give you an example.... GENERAL MOTORS -------------- Click for info on last Bloomberg article on GM. The US giant is going through a financial nightmare these days. Its CEO has said that he expects to run out of cash in the next months and he is asking "Daddy Fed" for help. As a matter of fact GM bonds, are trading at 25%/30% levels. (*) I am looking at GM 2033 in $. How can we make money? If we think that the US Government - I bet you my house that will be the case considering 1m. workers and 2m. indirect workers exposed - will help the auto maker, then we should long GM bonds. That would be equivalent to earning the recovery value - which we would get anyway if GM defaults - plus an option on the US helping them. That option is worth tons of money - from 25% to 100% notional! -. If we want to operate on a hedge fund fashion, we could simultaneously short the GM equity. Because one thing is not defaulting but a very different one is thinking that GM will increase their revenues any soon (which I doubt). So basically it is a view where we express: 1) Lack of growth I hope you liked the concept and the trading idea. See you next week. 
Posted on 12 Noviembre 2008 Trackback PingsTrackBack URL for this entry: CommentsReally informative! Posted by: A.S.Ahmed at Diciembre 1, 2008 12:43 AM Post a comment |
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