Cash & Loans Advice Blog

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would be better buyers of the bond and buyers of protection to maturity to lock in the positive carry.

Factors that widen the basis (positive basis):

• Strong demand from protection buyers such as banks or hedge funds
• Bonds can usually be funded in the repo market at or around Libor.
• If the bond becomes special the investor holds a repo market option that makes the bond more attractive than the CDS and tends to widen the basis (short positions in bonds cannot be locked in for years because of a nonexisting repo market).
• Deteriorating credit quality and increasing spreads/basis volatility or equity volatility (CDS = high beta instrument).
• Assets trading below par, that is an investor who pays $80 for $100 face value has less credit exposure than a protection seller at par. Therefore, the protection seller would demand a higher premium (spread) than the bond.
• Convertible bond issuance may lead to hedging credit risk to unlock “cheap” equity volatility.
• The cheapest to deliver option is a structural factor, which tends to widen the basis (protection buyer is able to deliver any qualifying loan/bond).

The default basis can also be viewed as a risk indicator. In general, the sale of default protection should be more attractive than purchasing a bond when the basis is high relative to the equity volatility of the firm and vice versa.

Make sure you use the proper credit strategy

Basis trades/Convertible bond hedging: As an example the basis for Fiat widened massively following issuance of a 2.2 billion convertible and deteriorating credit sentiment at the end of 2001. It is worth mentioning that the negative basis trade (long cash, long protection) is not entirely risk-free. If the bond is actually restructured at the time of default it is no longer deliverable. The risk-free positive basis trade cannot be set up till maturity because one is not able to lock in the repo rate of the bond (short cash, short protection).

Capital structure arbitrage: These might be strategies where investors take a position in a default swap versus an equity put option. If equity is undervalued, CDS levels are tight and debt is rich the following strategy appears to be appropriate. For example, selling out-of-the-money puts versus buying protection allows to position for a rally in the stock/declining equity volatility and to “hedge” this opinion against the risk of the widening of spreads on the company’s debt. The option premium earned is used to fund the CDS, with positive or negative carry. It is important to realize that this is not a pure arbitrage or risk-free trade.

If a credit event occurs…

Selling short-term and buying long-dated protection leaves a forward short position, which would benefit from a steepening in the credit curve and vice versa.

Senior versus subordinated CDS strategies: The senior-to-sub spread differential in CDS is driven fundamentally by expected recovery values. If senior spreads are half those of subordinated, then the expected senior loss following default is half that of sub. A 50 percent senior recovery (50 percent loss) would imply a 0 percent subordinated recovery (100 percent loss) A potential strategy is to sell subordinated protection and to buy senior protection (weighted). It offers the chance to unwind at a profit if the seniorto-sub ratio mean reverts to historical averages (positive carry trade). If a credit event occurs, the payoffs will reflect the actual relative recoveries in sub and senior debt.

When a credit curve is steep

On the other hand, if one has a negative short-term view on a credit but believes it to survive for the next 5 years, its credit quality will improve significantly. This view can be expressed via buying a long-dated 30-year par asset swap and buying 5-year protection on the single name thereby creating a long forward spread position (or buying short-dated default protection and selling longer dated default protection). This position would benefit from a flattening of the credit curve.

A steep credit curve implies a steep forward credit curve. A forward default swap is buying or selling protection for the given maturity at a given point in the future at the forward CDS spread. For example, Munich Re senior 2-year protection is at 21 bp and the 7-year protection trades at 34 bp. Selling 2-year protection and buying 7-year protection results in a 5-year CDS two years forward (2 _ 5 spread) at a level of 40 bp.

The best online credit decisions

The best online sales decisions blend past experience and existing resources with the dynamism and invention of the internet. One useful principle is to use the flexibility of the internet, effectively testing new decisions and ideas. The technology and culture of the internet enable one approach to be tested for a short period before making improvements.

Ten things determine the success of online business activities, some or all of which are useful to consider when deciding how to develop online sales:

• Content
• Communication
• Customer care
• Community and culture
• Convenience and ease
• Connectivity (connecting with other sites as well as with users)
• Cost and profitability
• Customisation
• Capability (dynamic, responsive and flexible)
• Competitiveness

Each of these exerts a significant influence on the success of online activities. Some are more important than others, depending on the organisation’s stage of development, brand strength and competitive position. Some are always important, such as capability and convenience, whereas others can assume a greater significance at a particular time (competitiveness, although always in the background, may assume a sudden and striking relevance).

The Grandosity Issue

Successful real estate speculation leads to grandiosity. Small real estate investors, who missed the stock bear market of 2000-2001, are prone to grandiosity.

Grandiosity, when returns are positive, manifests as extreme good humor and excitement. Grandiosity can be intoxicating. Once experienced, gamblers seek to recreate the high. Day traders continually believe they will have another streak. Tech investors search for the next Microsoft. Real estate developers crave breaking ground on the next mega project.

Yet, even on a winning streak, grandiosity has a down side. A sense of isolation is common. Sudden wealth stands out in a society where savings are accumulated slowly. Grandiosity can lead to a loss of connection with family, friends, colleagues, social norms, and even one’s self.

Grandiosity is often followed by both poor investment results and personal unhappiness. Crashing from grandiosity can be very painful. The detox process leads to grief, sadness, plummeting self-esteem, self-loathing, or depression. Thoughts of suicide are common. Actual suicide is the extreme manifestation of fallen grandiosity.

Although some people are not prone to grandiosity, you should consider any experience you might have with it.

Decreasing fixed expenses

Decreasing your fixed expenses can result in a huge jump in your discretionary income. Oftentimes, though, getting rid of or lowering a fixed expense can take a major lifestyle adjustment. But when you are battling to eliminate debt, the thousands of dollars you may save might well be worth it. Here are some ideas:

1. Ditch the ride. Over my years as a financial planner, I’ve seen few things that suck up as much discretionary income as a car payment. Add in the other costs such as gas, insurance, and maintenance, and you can easily spend $5,000 to
$10,000 per year for the privilege of sitting in traffic. One to two years of riding the bus or subway, or even carpooling with your accountability partner, may get you completely out of debt!

2. Put a smaller roof over your head. There are a lot of reasons why you may have needed a bigger house or apartment in the past. But since the kids moved out, the dog ran away, and you’ve sold a bunch of your stuff at a garage sale, you could make do with less space. A few hundred dollars less per month in rent will go a long way toward getting you out of debt.

3. Cancel your PMI. Mortgage insurance is required by most lenders when they loan you more than 80% of a home’s value. However, when your mortgage balance drops below 80% you are no longer required to pay PMI. Oftentimes, companies will continue to charge it until you ask them to stop. Canceling your PMI as soon as you’re eligible can save hundreds each month.

4. Cancel unused subscriptions/memberships. Whether it’s the gym or the newspaper, there are a lot of things that slowly nickel-and-dime us to death every month. A couple of canceled memberships or subscriptions could easily save $50 per month, or $600 per year!

5. Shop your insurance. If you haven’t updated your life, health, auto, or home insurance in the last few years, now may be a great time. Besides making sure you don’t have too much insurance, you may also find significant savings as you shop.

How to increase income

1. Rent out a room. If you own a house or are renting an apartment by yourself, you might be able to seriously knock down your debt by renting out a room to someone else. An extra $300 to $500 per month goes a long way!

2. Start blogging. You can start an online diary of your own, with ads built right into them, or you can sign on to blog for someone else. Blogging for someone else can pay anywhere from $3 to $20 per post, especially if you have a unique perspective or skill.

3. Freelance. If you have certain job skills or talent, ranging from bookkeeping to website design, you can make significant money working from home. Go to Google and search for “freelance websites” where you can bid on projects people need completed.

4. Tutor. Were you that kid who always got 102% on the math tests? Do you love American History or Spanish verbs? There are a lot of kids who don’t, with parents who are happy to pay $20 per hour for good tutoring. You can tutor on the weekends at your local coffee shop.

5. Turn your hobby into a home business. When we were really poor, my wife learned how to make beaded jewelry at her preschool mom’s group. We started using her creations in place of store-bought gifts, and it wasn’t long before people were asking how to buy them. She works when she wants and makes an extra $2,000 to $3,000 per year.

6. Open a home day care. If you are already a stay-at-home parent, taking care of a few extra kids besides your own can bring in significant money. After a few required classes and a safety inspection, you can start providing day care for other children at $8 to $15 per hour, per child!

7. Recycle. For years, I was that parent scooping up all the cans and bottles after my kid’s baseball games and at my office. The $10 to $20 per week I’d earn on Saturday mornings helped me overcome the weird looks I’d get from my coworkers.