Ever heard of a hedging position that multiplied 100x in value over a month? That too when the markets worldwide were going haywire due to COVID-19?
Hedge fund manager Bill Ackman and his firm Pershing Square Capital Management, L.P. are back in the limelight of Wall Street for a trade rumored to be one of the greatest ever.
A hedge fund is a highly unregulated pool of funds employing aggressive and unconventional strategies to beat market returns. It has an element of exclusivity as it’s only open to individuals with a certain minimum net worth.
Early this year, Ackman’s conviction and an appetite for calculated risks helped him multiply a modest sum of $27m into $2.6bn in just 4 weeks. Now the annualised return of this trade will be quite a number.
Credit Default Swaps (CDS), the derivative contracts which made headlines during the 2008 crisis were Ackman’s weapon of choice. He used it to his advantage to bet against (short) the corporate bond insurance indices. But unlike those who profited from the 2008 crisis, Ackman exited his entire hedge in just a fraction of the time.
A CDS works just like insurance. It protects the buyer against a default in payment of bond principal. Like in any other insurance (say life insurance), the buyer needs to pay a regular premium in return (spread), usually for five years. What makes it unique is that the holder need not own the underlying bond. Hence, these contracts are publicly tradable and highly liquid, allowing Ackman to short the corporate bond market by end-february.
Due to persistent favourable conditions for borrowing, the costs to insure against defaults were at historic lows when Ackman bought the hedges. This allowed him to amass insurance linked to $71bn of notional for a meagre spread of 0.5%. In short, he was betting against almost 1% of the entire investment grade corporate debt market in the US.
Less than three weeks later, the markets priced in the fear of COVID-19 and the spread on his CDS tripled. Insurance contracts against corporate bond defaults were suddenly in high demand. With fewer sellers and more buyers, Ackman’s hedges had multiplied 100 times in value.
This trade exemplifies the brighter side of anticipating market disasters and subsequent profiting. With $27m in premium payments every month, we wonder how he would have fared had COVID-19 been just an epidemic like Ebola or SARS.
Disclaimer: Views expressed in content linked to this website or posted in social media are by Ananthu Santhosh and Aseem Mehra and are personal. The information is not directed to any investors or potential investors, and do not constitute an offer to sell — or a solicitation of an offer to buy — any securities, and may not be used or relied upon in evaluating the merits of any investment. The content should not be relied upon in any manner for the purposes of investment, legal, tax, or other advice.