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Today's Investors Aren't Buying the Dip, They're Buying the Flip


Investors aren't allocating capital to investments in companies; they are trying to exploit prices at somebody else's expense.

This week Bloomberg reported a sad story that epitomizes today's quantitative easing-induced investment climate. The following is from a story titled "Blackstone Unit Wins in No-Lose Codere Trade" by Stephanie Ruhle, Mary Childs, and Julie Miecamp:
GSO Capital Partners LP provided a loan to Spanish gaming operator Codere SA (OTCMKTS:CODEF) in June with terms that gave it a guaranteed return on credit-default swaps, outmaneuvering sellers of the protection.

The unit of Blackstone Group LP (NYSE:BX) structured the loan in a way that would lead to a payout on swaps it held, according to three people with knowledge of the situation who asked not to be identified because the discussions were private. The contracts were triggered on Sept. 18 after Codere delayed an interest payment by two days to comply with the loan terms.

The company's willingness to pay the coupon late helped ease restructuring negotiations as many bondholders also held credit-default swaps and would benefit from a missed payment, the person said. Codere made the August payment two days after a 30-day grace period, and the International Swaps & Derivatives Association ruled that there was a failure-to-pay credit event, resulting in a $197 million payment to holders of the swaps.

Unreal. This is how investors make money in today's market. It's not about creating value; it's about profiting at somebody else's expense. This is what happens when real rates are negative. This is a product of the Fed's monetary policy where there is no long-term capital allocation; there is only short-term capital exploitation.

This risk-free exploitation reminded me of a condition present at the top of the credit bubble. I remember reading an article in the Financial Times about corporate bond investors taking advantage of the insatiable demand for structured products that sold credit protection to juice returns. The following is from "'Negative Basis' Is Easy Money" by Michael Mackenzie:
When it comes to easy money, it is hard to overlook a dramatic distortion in the credit market that has generated virtually risk-free returns for some investors in recent months.

For some companies, the annual cost of buying credit protection has fallen below the risk premium, or spread, a bond investor receives on the same company's bonds over and above the benchmark risk-free interest rates.

This situation is known as "negative basis."

Investors can buy both bonds and CDS protection, leaving them with net credit risk of almost zero but still able to pocket a spread above risk-free rates.

Strong investor demand for credit exposure in derivative form is still supporting the negative basis trade -- in which the bond investor takes the other side of the trade in the derivatives market. A particular source of demand for credit risk has been structured investment vehicles such as collateralized debt obligations.

That was the top. There was not enough yield in vanilla CDOs so investors looked to structures that sold credit protection as a way to get levered long credit, thereby enhancing returns. The demand was so great that it fostered a relationship that should never happen. Credit protection was cheaper than credit risk. This wasn't a product of long term investment; this was short term capital exploitation. This is what happens when short term capital rules the market. This is what happens when the cycle is mature and there is no intrinsic value left in price.
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