Biotech Values

[DewDiligence]

Here’s an amusing instance of market inefficiency from Tuesday’s WSJ.
(Note: the James Bianco mentioned in this article is not the CEO of CTIC.)

http://online.wsj.com/article/SB10001424052748704762904575025363099612820.html

›Default-Bet Anomaly: Firms Over Countries

By GREGORY ZUCKERMAN
JANUARY 26, 2010

Worries about the heavy debts of a number of countries have gotten so extreme in some places that investors are betting that some businesses in those nations are more creditworthy than the nations themselves.

The investors are making the bets using credit-default swaps, which pay off when a bond defaults. Buying protection on companies usually is more expensive than buying it on countries, which rarely default.

But, lately, it has become more expensive to buy protection for the debt of a range of countries than it is to purchase similar protection for some companies in those nations. It is as if investors are betting that the government of Spain, for example, has a greater chance of defaulting on its debt than do some Spanish banks.

The anomaly reflects nervousness about all the debt racked up by various nations, as well as relative optimism about some top-rated companies with healthy balance sheets.

Of course, some investors have been buying credit-default-swap contracts that insure the debt of various nations, not because they expect defaults, but because they are wagering that sentiment about those nations will continue to sour, and that the price of CDS insurance will rise as a result.

At the same time, the market for credit-default-swap protection isn't always active for many issues, and that can cause odd distortions in the market, some analysts say.

The unusual pricing is attracting hedge funds and other traders wagering that it can't last over the long haul. These investors are buying relatively inexpensive protection for the debt of a range of companies, while simultaneously selling more-expensive protection for the nations these firms are based in. Though, at times in the past, debt of companies has been more expensive than debt of countries, traders say the anomaly doesn't usually involve so many companies for such a long period.

The assumption behind this trade is that countries generally are better risks than are companies, if only because countries can raise taxes [duh]. And if one of these nations runs into trouble paying its debt, companies in those countries also likely will be crippled. "Companies within a country can't be better credits than a country itself because they have the power of taxation. They can always use that to prevent a default," says James Bianco, who runs Bianco Research in Chicago. "It's kind of an irrationally priced market."

Those focusing on this trade often are smaller hedge-fund firms, such as the $300 million Xaraf Management LLC. But some larger funds are doing versions of the trade through indexes that can trade actively, traders say. They are shorting, or betting against, indexes that track corporate bonds, for example, while buying indexes that track sovereign debt.

One place they are watching: Spain. Five-year CDS contracts that protect $1 million of debt of Spanish banks, such as Banco Santander SA, cost about $10,500 annually; but it costs about $12,000 to buy similar protection for Spain's debt itself. The hedge funds are wagering against the banks' debt and for improved interest in the debt of the country.

Meanwhile, it cost about $11,000 to insure Italy's government debt, but between $8,300 and $9,500 to buy similar protection on some Italian companies, such as Italian bank Intesa Sanpaolo SpA and electricity company Enel SpA. It is true in some cases in Ireland as well.

The phenomenon also can be seen in some instances in the U.S. It costs $3,500 to $4,100 annually to buy credit-default swaps to insure $1 million bonds of both Merck & Co. and Coca-Cola Co., but about $4,500 to purchase CDS contracts to protect comparable US Treasurys.

Those involved in the trade acknowledge that it might not work for some time. If the fiscal health of various nations worsens, CDS contracts on that debt could become even more expensive, hurting these traders.

At the same time, today corporations often have less debt relative to their assets than some nations, as well as better prospects, making it dangerous to bet against this corporate debt. There is a limit to how much countries can raise taxes, of course, so nations mightn't be in a better position than some strong companies, skeptics say.

Still, some firms, like Xaraf, see their trades as long-term moves that will pay off. "Given the power that nations have to raise revenue, we believe the risk of loss in sovereign debt is lower than in debt issued by companies and banks located within the country," says Chris Walsh, a partner at Xaraf.‹