Bottom fishing for relative value

A recent trade we did in the credit income world

For those who have paid attention to what we have been doing lately, one thing must be obvious - we love relative value trades in all realms - but mainly in equity and fixed income.

To begin with, let’s briefly state what relative value trades are:

1. Those are trades in which one believes 2 assets are mispriced relative to each other. Usually, such a trade would rely upon mean reversion to what has historically been established as a more “fair” relationship of the two assets

2. They are often directionless in the sense that the goal is to profit from the difference in the price movements between the instruments, rather than the direction of the broader market.

3. They involve both a long and a short position simultaneously but the two sides could vary in terms of size

Before going to the real-life examples I want to introduce you to Harkster. They are building an amazing platform through which you can sort out all of your financial content in a Twitter like feed. It is amazing what they are doing. Give it a try.

Now let’s go to some real life examples and how we found them.

While it is true that the market has been rather dull lately, there has been some niches where much more has been going on below the surfice. The broader indices have stayed more or less flat for the last month and are up nicely year to date.

What if I ask you about which companies/subsectors have performed worse? I am pretty sure your answer would be commercial real estate and you would be more than right. However, there is another subsector that has taken quite the beating - telecommunication services.

What has been the complete opposite of stability (despite the heavy asset base that is to benefit from the inflation narrative) is the performance of companies such as DISH, CHTR, LUMN, ATUS and USM, to name a few. By now our readers should know we are the furthest away from fundamentalists and we generally try to stay away from idiosyncrasies but a simple look at some charts screams that something is very wrong within the subsector.

A quick look at the companies about them gives a good overview of the trouble inside the sector - existential threat from new technology, heavy capex required and huge debt to be rolled and serviced.

Well, if there are signs for distress in credit, we surely get excited. And by bottom fishing in the murkiest of waters, we got to our last trade:

Long UZE and UZD and short USM 6.7 33

This trade is a relative value trade and has the features of a capital structure arbitrage. The beauty here is there is little difference in the seniority of the products discussed - all of them are senior unsecured debt. The main differences between UZE and UZD, on one hand, and USM 6.7 33, on the other hand, are:

a) call dates - but those are a bit meaningless (i.e. unlikely to be called given where they are trading)

b) coupons - 5.5% for UZE and 6.25% for UZD vs 6.7% for USM bond

c) maturity dates / duration - UZE and UZD mature in 2070 and 2069, whereas USM matures in 2033

While it is true that shorter maturity issues deserve to trade at a premium against those with longer maturities, I find it hard to believe that the distress here justifies such a difference in price.

UZD trade at $16.62, or at 66c on the dollar while UZE trades at $14.65 or 59c on the dollar, given that the par value for both issues is 25$.

At the same time, the same seniority bond, maturing in 2033, trades around 92$, or 92c on the dollar, given that par here is 100$.

One can see how the relationship of the exchange traded bonds (UZE, UZD) has performed against the OTC bond (USM 6.7 33):

The ratio is near historic lows and appears to be driven by forced selling0. in the exchange traded products (UZE, UZD) and here the opportunity for some mean reversion arises. I believe there is some juicy opportunity here and the ratio could easily go back up to 0.2 for a c. 11% profit, making a long in UZE and UZD and a short in USM 6.7 33 more than justified.

Here comes the tricky part though - how do we construct the trade in the most efficient way, given the big difference in duration (sensitivity to changes in rates given difference in coupon and time to maturity of the long and short products)?

Calculating duration based on current market data and the years to maturity gives 10.1 for UZE and 10.18 for UZD.

On the other hand, the shorter maturity bond has a duration of 7.143.

Therefore, a duration adjustment would require us to put approximately 10.14 / 7.14 or 1.4x more size in terms of notional value in the USM 6.7 33. However, this seems a bit too little if there is a true risk to the downside, and despite that putting more on the short side leads to increasing negative carry, we are ok with it as credit spreads could be well expanding with the broader market falling. We have decided to press the short side a bit more and aim to have 2x the notional dollar amount that we are long.

We must not forget to mention that there is yield curve risk we are sitting on, as the relationship between the treasury 10y and 30y rates could move. Hopefully, if necessary, one could readjust the ratio of the long and short parts of the position, accordingly.

If you are interested in more relative value trades in the credit space, carry trades with the potential for capital appreciation and positive carry or when and why we think it is appropriate to hedge once portfolio, you should consider becoming a paid subscriber. By doing so you will get access to our 17 year veteran trades and his team of talented traders for a fraction of what you will pay to hire an inhouse analyst or trader.