I am reading a research report from ML about CDS. There is a sentence the research piece that says “Credit derivatives provide liquidity to short sellers. Prior to their introduction it was hard to short credit due to the lack of depth in term repo markets.” I am trying to understand how a transaction occurs in the repo market that allows a person to get short a credit. Could someone please explain how this transaction would occur? Lets assume that a PM owns a bond that they don’t like but they don’t want to sell it outright. Thanks in advance.
Suppose I want to short a GM bond. If I can find someone who wants a repo loan on that bond, I borrow the bond and give him the loan. Then I sell the bond to someone else while I have a contract to return it at some fixed price in the future. I’m now short the bond. Of course with the sale proceeds, I can do it again and lever up pretty much except the haircut on a bond like that is pretty big and the liquidity is not very good. Buying CDS on that bond might be pretty easy. The PM who owns the bond could borrow the bond from someone else in the repo market and sell it . That makes him neutral, I guess, but the exact tax consequences and accounting of that are not known to me.
I’ve seen shorting of bonds done through bond forward contracts which in essence is a form of repo, just w/ out the bond or cash actually changing hands. If I am a PM, I enter into an agreement to sell a bond at a set price at a forward date. If bond prices decline I’ve effectively made money on my short. In practice, I’ve rarely actually seen deliverance of the bond rather a net cash settlement prior to or on forward termination date.
There are a few differences here: 1) A forward contract probably doesn’t require margin or have any marking-to-market so my counterparty risk is the entire extent of my gain. A repo typically has both an initial haircut and a system of margin calls if the collateral becomes impaired. My counterparty risk is much less in the repo short. 2) Repo agreements are more standardized than forward contracts. 3) Cash-settling an illiquid bond is tough.
thanks for the response. couple of questions. in the first transaction with the investor who originally owns the GM bonds, i have sold their GM bonds to someone else at a price but i owe the original investor their GM bonds back at the end of the repo date (at what price?). what happens if i cant find the same bond to give back to the original lender of the GM bond? Do i just enter into another repo trade with them? also, just for clarification the I own the GM bonds in the first transaction as collateral for the loan i gave. They (the originally owner of the GM bonds) have a margin requirement to ensure that the collateral (GM bonds) doesn’t lose value and I am out money if I need to take ownership of the bonds. Right? Also, regarding accrued interest, the original owner of the GM bonds receives all of the interest earned during the length of the repo (yes/no). thanks again.
contango1 Wrote: ------------------------------------------------------- > thanks for the response. couple of questions. in > the first transaction with the investor who > originally owns the GM bonds, i have sold their GM > bonds to someone else at a price but i owe the > original investor their GM bonds back at the end > of the repo date (at what price?). At the price given in the repo contract which is the price that means the provider of cash gets the repo rate on the loan. > what happens > if i cant find the same bond to give back to the > original lender of the GM bond? Then there is a “settlement fail” which is not really a big deal if it just lasts a short time. In general, you get a one-day grace period to deliver at the invoice price. After that, it becomes a default on an obligation and is handled just like any other default. If the bond is really so illiquid that one isn’t available at any price, it was a very strange choice to short and you are going to pay. > Do i just enter > into another repo trade with them? also, just for > clarification the I own the GM bonds in the first > transaction as collateral for the loan i gave. > They (the originally owner of the GM bonds) have a > margin requirement to ensure that the collateral > (GM bonds) doesn’t lose value and I am out money > if I need to take ownership of the bonds. Right? Right. > Also, regarding accrued interest, the original > owner of the GM bonds receives all of the interest > earned during the length of the repo (yes/no). > thanks again. No the owner of the GM bond is paying interest for the loan. He does get to keep all the coupon payments on the GM bond even though that bond is off being bounced around the world.