Hedge fund losses over GM reveal how these strategies can go awry when correlation assumptions come undone. One popular correlation trade was to buy GM bonds and hedge by shorting GM stock. However, an almost 20 per cent rise in GM stock after Kirk Kerkorian’s bid to raise his stake in the company, followed the next day by Standard & Poor’s downgrading of GM’s credit below investment grade status upended those correlation assumptions. Hedge fund investors lost on both their debt and stock bets.
Similarly, correlation trades based on how riskier tranches of collateralised debt obligations (CDOs) would behave relative to less risky portions broke down when GM and Ford were downgraded.
The next downturn in the credit cycle will be a litmus test for the latest generation of hedge fund strategies and the derivative instruments they use. CDOs have become enormously complex as single issues have spawned multi-layered baskets of CDOs with complicated underlying risks. The next two quarters could be a bumpy ride for credit markets as more companies see their credit quality decline (eg. Maytag and Eastman Kodak).
Many credits, including GM, bounced back significantly in the past few weeks, causing investors to wonder whether the market had found its footing or was simply waiting for the next wave of spread widening. One bright spot in volatile credit markets, however, could be securitised assets, such as asset-backed securities, mortgage-backed securities and commercial mortgage-backed securities, which have been more insulated from correlation trades and are likely to outperform as the correction in the corporate bond market continues. But, as the yield curve flattens and levered positions are unwound, caveat emptor is still perhaps the best advice for bond investors.
Sean P. Flannery, chief investment officer of North America and head of fixed income, State Street Global Advisors
