Tuesday, April 22, 2008

Bargains for high-grade bonds drawing in hedge funds

LONDON (Reuters) - The credit market turmoil is presenting opportunities for funds to snap up investment grade bonds at bargain basement prices, particularly among financials, but the window of opportunity is unlikely to be open for long.

With hedge funds and other nimble investors coming back to the market, and historically wide spreads -- the premium firms pay to borrow money over risk-free bonds -- beginning to narrow, corporate credit at current cheap levels is unlikely to last.

"You've got to move fast," said Ken Kinsey-Quick, who runs around $2.3 billion in funds of hedge funds at Thames River Capital, and who last month invested about 2 percent of total assets under management in an investment grade credit portfolio specially set up for him by Cheyne Capital.

"We spoke to a (Cheyne Capital) manager and they said, 'if you want to take advantage of this you've got to do it in the next week... You've got a couple of days to make up your mind'."

Nevertheless, market opportunities remain after recent sales by banks keen to raise cash and by hedge funds under pressure from investor redemptions and prime brokers tightening credit.

Investors tend to sell more liquid assets -- in this case investment grade rather than junk -- first when they need to raise cash quickly.

The dearth of buyers, fearful of the impact of the credit crisis on the wider economy, has also pushed spreads wider.

Investment-grade euro corporate bond spreads had surged to 178 basis points by April 17, after spending much of 2006 and the first half of 2007 at lows of 45-55 basis points over government bonds, according to data from Merrill Lynch.

Spreads peaked at 191 basis points on March 17 when JPMorgan (JPM.N: Quote, Profile, Research) announced it would buy Bear Stearns (BSC.N: Quote, Profile, Research) to save it from collapse.

"You've had a massive sell-off in corporate bonds because banks have had to get rid of them off their balance sheets, because they're having problems elsewhere," said Kinsey-Quick.

"It's all investment grade, that's the nice thing... You can now invest in these bonds which you're picking up for 70, 75, 80, 85 cents in the dollar and all of a sudden you're getting a strong double-digit annualized return."

RIGHTS ISSUES HELP

Rights issues, like the one Royal Bank of Scotland (RBS.L: Quote, Profile, Research) is planning, also make bonds more attractive to investors as it means the issuer is building up cash reserves while passing on the pain of the current crisis to equity holders.

"Although bank shareholders may be bruised by write-downs or diluted through rights issues, bondholders are less affected by such events," said Murfin.

"Indeed capital raisings are good news for subordinated bondholders because it replenishes the capital buffer lost as a result of losses from subprime assets."

Although defaults are expected to pick up from current historically low levels, the strength of investment grade balance sheets adds to the current opportunity

"Now is the time to add risk if one takes the view that the (bank) writedown debacle is nearing an end or has peaked," said Suki Mann, a credit strategist at Societe Generale.

"This unprecedented yield difference with government bonds is unlikely to last for long," said Owen Murfin, manager of BlackRock's MLIIF Global Capital Securities Absolute Return fund, who favors subordinated bonds of financial institutions.

"When the gap closes investors in subordinated bonds will enjoy gains in capital value." Subordinated debt ranks behind senior debt but ahead of equity.

Ironically Murfin, like many other managers, sees the best opportunities among financials, whose share prices have tumbled since the onset of the U.S. subprime meltdown last summer on concerns about the strength of their balance sheets.

"We think credit in the financial sector is now very attractive and is offering a higher risk premium than equities. HBOS raised 750 million pounds at a 9.6 percent yield last month," said Patrick Armstrong, who runs around 950 million pounds at Insight Investment.

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