Happy Times and Others as a Fixed-Income Strategist

Steve Antczak was a fixed-income strategist at Wall Street firms for 21 years, providing customers with market commentary and trade ideas. Being head of leveraged finance strategy at UBS in the 2000 aughts was a particularly productive phase of his career. He describes the financial environment and two types of trades investors executed to good and bad results.

I liked the challenges of being a fixed-income strategist at Wall Street security firms. Financial markets are complex and prices depend on many factors, many of which are subjective. Competition to provide financial services to investors is tough, and a competitive environment brings out your best. Finally, the stakes for a strategist are high and often binomial: you might get a big bonus or you might get fired.

But I didn’t realize how much success depended on luck and being in the right place at the right time. Fortunately for me, I was in the right place at the right time in 2001 when UBS hired me onto its fixed-income strategy team.

In terms of the right timing, credit markets in 2001 were experiencing an extraordinary evolution, and change creates opportunity. Many US companies had decided it wasn’t so important to have a triple-A, double-A, or even a high single-A credit rating. Equity capital was costly, debt capital was cheap, so why not issue debt to fund operations, expansion, or stock buybacks? So, corporations levered up. In the four years 1998-2001, US nonfinancial corporate debt increased 56%, to $3.9 trillion dollars.

But the growth in cash credit markets paled in comparison to the growth that was about to occur in credit derivatives. Credit default swaps (CDS) are a way to go long or short credit risk without buying or shorting a debt instrument. An investor goes long (short) a corporate’s credit risk by selling (buying) credit protection via CDS. The protection buyer makes periodic payments, like insurance premiums, to the protection seller. If the corporate defaults, the protection seller pays default losses to the protection buyer. Outstanding CDS notional increased from $1 trillion in 2001 to $60 trillion in 2007.

In terms of being at the right place, UBS had built the world’s largest trading floor in Stamford, Connecticut and Robert Wolf, Global Head of Credit Trading, Research & Distribution, took advantage of its location. He was able poach very senior, very experienced, and very successful credit market professionals who lived in Connecticut and Westchester County, New York and who were sick of commuting into Manhattan.

Instead of Metro North and subway trains and a three-hour-plus round trip each day to lower Manhattan, a person could drive his car into UBS’ parking garage and never get wet, cold, sweaty, or frustrated at train delays. These professionals wanted more time for themselves and their families and Robert took advantage.

The recruiting advantage meant that very talented professionals with expertise in many different areas were all sitting on UBS’ giant trading floor. This was great for fixed-income strategists like me. I could walk around the floor after the morning meeting ended at 7:30 am and talk to Mark Davis, who was in charge of the UBS loan book, to learn what he was worried about. I could talk to Sal Naro, who headed up CDS trading, to understand what flows he was seeing. I could speak in depth with repo traders, equity salespeople, proprietary traders, equity derivative specialists, and credit analysts, among others. In one hour, I could get a pretty good sense of who was doing what and why in any market.

UBS credit was also the right place because of its results-oriented business culture. My boss, Ken Elgarten, came from Lehman Brothers, a firm with a wonderful reputation in credit research. But the problem, as customers saw it, was that its research was too theoretical. Many of Lehman’s ideas could not be executed in practice.

Ken, and the credit business as a whole, wanted actionable research. Ken didn’t merely want profitable trades ideas. Ken wanted trade ideas that UBS customers wanted to do and that UBS traders could execute. And he wanted the trade idea to be profitable. Results mattered.

This customer-focused mindset was true throughout UBS’ credit business. One salesman, Gary Stanco, screamed and fought with Treasury traders over half a tick (1/64th of a percentage point) on behalf of his customers. Jeff Wilner, a former tight end for the Denver Broncos, examined the spreadsheets underlying our trade recommendations to make sure the trade made sense for his customers. Customers appreciated that Gary, Jeff, and other salespeople bent over backwards for them, and business flowed to UBS credit as a result.

Like any trading floor back then, we also had our fun, usually involving bets and dares. A senior analyst once ate his dinner dog style, without utensils or hands, to win a $200 dare. And the dinner of sea bass, risotto, and creamed spinach wasn’t easy to eat that way. Over on the CLO desk, two traders from different regions in India argued over whose cuisine was spicier. The bet to settle the issue involved one trader ingesting a teaspoon of hot sauce. The “winner” of the bet admitted he spent the rest of the day in a semi-conscious fevered state, writhing in his car in the parking garage.

The credit crisis of 2007-08 brought ruin and opportunity. I’ll walk through two specific trades that fall into categories that I call “market-is-wrong trades” and “catalyst trades.” One was a loser and the other was a winner in 2007. But I would argue that 2007 wasn’t exceptional, and that one should always be wary of market-is-wrong trades and that one should always look to take advantage of catalyst trades.

The Market-is-Wrong Trade

In 2006 it was possible for hedge funds and bank proprietary trading desks to buy triple-A-rated CLO tranches yielding Libor + 25 basis points and finance their purchase at around Libor flat. The twenty-five-basis-point difference was the trade’s positive carry. If the hedge fund didn’t want to assume the credit risk of triple-A CLOs, it could buy credit protection from a triple-A financial guarantor, like Ambac or MBIA at, say, 12 basis points.

It appears that the market is wrong, or at least different parts of the market disagree. The CLO market is saying the risk of triple-A CLO tranches is 25 basis points, the spread above Libor. But the CDS credit protection market is saying the credit risk of the same CLO tranches is 12 basis points, the cost of default protection. Buying default insurance reduces the carry to 13 basis points, but this seems like a pretty riskless strategy. After all, to sustain a credit loss, both the triple-A CLO and the triple-A financial guarantor have to default. So, the hedge fund receives a very-safe “arbitrage” profit of 13 bp. And while 13 bp isn’t much, as one trader put it, “if you put a billion dollars into the trade, it’s real money.”

But the risk inherent in this trade wasn’t credit, it was financing. CLOs mature in years, but funding was typically overnight. When the Great Financial Crisis took hold in 2007, multiple sources of funding became more expensive or dried up altogether. Banks were under pressure to de-lever and had to limit funding to their customers. The repo market demanded higher haircuts and higher interest. And investors pulled their cash out of hedge funds.

This was a very popular trade, and when funding dried up a lot of hedge funds had to unwind the trade at the same time and triple-A CLO prices collapsed. I went to see a potential CLO buyer in Greenwich, Connecticut. He agreed that triple-A CLOs were money good and that at a 15-point discount to par (where we were offering them) they had a compelling return. But I was the third guy pitching CLOs that week and the customer was waiting for the price to drop further. If memory serves, triple-A CLOs bottomed out around 70 cents on the dollar, for an investment that ultimately proved money good!

The Catalyst Trade

Another type of trade we highlighted to clients centered around the concept of “catalysts,” or events that would cause valuations to change over a specific, usually short, investment horizon. One example was the CDS flatteners we pitched to investors in 2007. A CDS flattener is a bet that the difference in premiums between short- and long-maturity CDS on the same name will compress or invert.

Normally, CDS premiums increase with time; the annual premium for a two-year CDS is greater than the annual premium for a one-year CDS. For a healthy company, the risk it will default in the next year is less than the risk it will default in the year beginning one year from now. It takes a while for a healthy company to deteriorate, so its default risk is greater in a year than it is now. CDS premiums reflect this, and the normal CDS premium curve, the plot of annual CDS premiums across CDS tenor, is upward sloping.

But if a company is in immediate peril, its one-year CDS premium can rise to or even above the two-year premium. The implicit reasoning is that if the company gets through this difficult year without defaulting, it’s less likely to default next year. Companies in trouble have downward sloping or inverted CDS curves.

I was doing my rounds on the trading floor and stopped by to speak with Jeff Teach, head of corporate loan trading, to ask how problems in residential mortgages might affect leveraged loans. Jeff said it might be a problem down the road, but right now he wasn’t concerned. Loans are senior securities, are floating rate, have their own buyer base, and are a bit isolated from troubles elsewhere.

It was interesting that this same mindset, “residential mortgage problems won’t spill over into my area,” was echoed by a number of other department heads and was more commonplace that I expected. This mindset existed even in market segments with obvious connections to residential mortgages, such as homebuilders. In fact, CDS premiums for homebuilders were still upward sloping.

This seemed like an opportunity, so we put together a trade package for a number of clients, including one of Jeff Wilner’s: buy three-year credit protection on a homebuilder and sell five-year credit protection on that same homebuilder. We were able to duration-match the two parts of the trade by buying 1.5 contracts of three-year CDS for each five-year CDS contract sold. With this ratio, the trade still had a positive carry: the customer received more premium from selling five-year protection than he paid in premium for three-year protection, even though he bought more three-year protection.

The result was that on a net basis the customer owned a lot of insurance that he could just sit on. If nothing happened and housing problems were isolated, no problem. He actually made a few basis points. But the housing market was under pressure and that was certainly a potential catalyst for heightened default risk among homebuilders. If so, the value of the protection he bought would rise relative to the value of the protection he sold and he could unwind the trade at a profit.

He had a trade with what I call asymmetric risks and a near-term catalyst. If housing troubles didn’t spillover to homebuilders, that was already priced in, he was earning a positive carry, so not much vulnerability at all. But if housing troubles did spillover and homebuilder default risk rose, the net extra insurance he owned would be deeply in the money.

Mortgage problems did spill over to homebuilders and this trade made money for Jeff Wilner’s customer in 2007. The market eventually recognized that homebuilder default probability had increased and that increased default probability was reflected in CDS premiums. Homebuilder CDS curves flattened, and the customer was able to unwind the trade for a profit. Homebuilder CDS curves ultimately became inverted, many severely.

Why not keep holding the position while homebuilder credit quality continued to deteriorate and CDS curves continued to invert? Because as the credit crisis wore on, non-fundamental factors come to the fore. A customer’s risk manager might force him to unwind the trade at an inopportune time to shrink the balance sheet. The government might intervene and prevent homebuilder defaults. It was better to harvest the profit before such events.

Also, there wasn’t much incentive to take further risk in search of higher profits. The individual Jeff worked with probably wasn’t going to get compensated for the profitable trade he put on, even if the trade made more money. His firm’s stock price ultimately fell about 90% and government intervention was looming. Bonuses were going to be meagre and it was more important to avoid a loss rather than stretch for further profit. There was no incentive for the individual to take the risk the trade might move against him.

One of the most important things I learned at UBS was to be wary of trades based on the theory that the market is wrong. The market is rarely wrong and instead it is more likely the market recognizes a risk you don’t appreciate. The other important thing I learned at UBS was that identifying catalysts is key to most good trades. If a trade appears to have asymmetric catalysts, take advantage. Surprisingly few investors focus on this, yet this is where opportunity often lies.

Epilogue

Mark Davis and I were befuddled when we read this quote from Chuck Prince, Citigroup Chairman and CEO, in the second half of 2007, “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” But very clearly, the music had already stopped. In fact, in late 2007, the radio was turned off, unplugged, packed up, and put in the closet.

When the sell-side was finally forced to accept that the music had stopped, the fallout would be extreme. I had a wonderful time at UBS, and pre-crisis I was undoubtedly in the right place at the right time. But the world had clearly changed, and as the quote above illustrates, many sell-side shops were resisting the change. When they finally capitulated to reality, the fallout, in terms of layoffs and reduced compensation to remaining staff, was going to be ugly. It was clearly time to leave. Strategy and research at a bulge bracket firm post-crisis was no longer the right-place and right-time.

After leaving UBS in 2009, Steve was a strategist at Cantor Fitzgerald, Societe Generale, and Citigroup; and an adjunct professor at Fordham University teaching practical investing. Steve currently lives in Shanghai, China and focuses on investment consulting and developing innovative ways to teach students how markets truly work.

The music stopped for Chuck Prince on 4 November 2007 when he retired from Citigroup after its third quarter net income declined 60% from the previous year and as its full-year net income was on its way to an 83% decline.

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Copyright © 2022 Steve Antczak. All rights reserved. Used here with permission. Short excerpts may be republished if Stories.Finance is credited or linked.