Capital Structure Arbitrage – A New Bold Arbitrage Play
What is Capital Structure?
Capital Structure
refers to the mix of equity and debt that a firm uses to finance operations of
the firm. An ideal capital structure can be used to optimize the value of firm
in a significant way. The
Miller-Modiginalni
(M-M) model on capital structure was one the first theory to explain the use
and benefits of capital structure in maximizing the value of the firm. Even
though the M-M model suffers from naïve and impractical assumptions, it still
forms the basis of subsequent research and thought process on capital
structure.
When
a firm borrows money as debt, it adds significant amount of value to the firm
by way of tax shield. When the firm raises debt, the form also incurs an
implicit bankruptcy cost. The optimal debt equity ratio tries to maximize the
value of firm. Some of the more practical approaches than the M-M Model that
could be used to arrive at the optimal capital structure are:-
- Enhanced
Cost of Capital Approach – The approach tries to generate a debt equity
ratio that would minimize the cost of capital of the firm. As the firm
increases the financial leverage, the levered beta of the firm would start to
increase. Hence higher leverage would get reflected as higher cost of equity.
Higher leverage would also mean the increase in risk for bond holders. This
would lead to increase yield of the bonds and fall in credit rating of the
bond. The cost of capital at various leverage points can be studied to find the
minimum cost of capital which would maximize the value of firm.
- Adjusted Present
Value Approach – This approach tries to maximize the value of the firm by
factoring in the implied bankruptcy cost and the gains on account of tax shield
to the value of unlevered firm. The tax
shield can be calculated by the using the marginal tax rate of the firm. The
value of unlevered firm is obtained by discounting the cash flows by the cost
of equity calculated by using the unlevered beta.
Calculating the bankruptcy
is a difficult task as it is an implied cost and it is a relatively a newer
concept in the world of finance. Some of the methods that can be used to
estimate the bankruptcy cost are –
- Using past Bankruptcies in the related industry,
- Altman Z score,
- Merton Model,
- Predictive Bankruptcies using option pricing
models
The
value of the firm depends on the debt equity ratio of the firm. But markets are
the efficient and they do misprice the securities. But there are special times
where one of the securities of the firm gets mispriced and leads to an
arbitrage around the two securities.
What is Capital Arbitrage and How does it
work?
Historically,
the arbitrage strategies have been built around correlation of related markets
such as – cash, equity-equity derivatives and cash bonds-interest rate futures.
Capital Structure Arbitrage is a relatively new strategy that intends benefit
from mispricing of the different liabilities of the same company. These were
developed after it was noticed that impact on credit derivative instruments
such as credit default swaps were found on the equity instruments of the same
company.
Potential
Arbitrage opportunities exist in the market if the price of debt or equity
cannot be justified by its capital structure. Capital Structure Arbitrage
Theory Involves taking long and short positions in different items on the
liabilities of the same firm. One of the reasons why this strategy could be
practically implemented with a “high degree of effectiveness” to benefit from
the mispricing is due the development of credit derivative market and
instruments such as CDS and CLN.
The
strategy works on the premise of exploiting lack of integration and
synchronicity between the equity and the bond market. The strategy is primarily
a bet on convergence of the anomalies in the pricing of different securities. The
strategy works the best when the firms in financial distress, survive and fails
the most when the firms end up in bankruptcy. It is far safer/less riskier than
a “Naked’ position in either market.
Link between Equity and Debt
The
credit risk of a company gets reflected in both equity and debt. The debt can
be viewed as put option and equity as a call option. Hence, debt is less
sensitive to company fundamentals than equity, especially when the fundamentals
improve. Higher the leverage, the credit spread of the company increases, this
increases the higher the correlation between equity and debt. Generally, debt
instruments with a rating of BBB-/BB+ are the best to execute the capital structure
arbitrage strategies, as this is where the correlation between equity and debt
is the highest. This reason why
effectiveness of debt instruments with a rating of BBB-/BB+ improves is because
these debt instruments are quite volatile and start behaving like equity to
various developments of the firm.
A
typical Capital Structure Arbitrage
- A investor believes either the debt or equity is
underpriced
- He purchases a put option on the equity and CDS
on a cheap bond (with a high YTM)
- He has build a kind of hedge by buying both
these securities
In
case of a default by the firm, he receives the money from the put writer and
the compensation from the CDS issuer. In case of recovery/non default, the
investor benefits from the improvement in credit position of the firm by
holding CDS and losses the premium paid for put option.
Some
of the traditional ways/strategies of benefitting from the capital structure
arbitrage are -
- Set-up trades between the debt and equity of a
company
- Play between senior debt and junior
securities
- Convertible Bond Arbitrage by purchasing
convertible bond and shorting the shares
in the delta hedge ratio
Some
of the newer strategies are
- Equity Options
- Credit Derivatives
- Using both Equity options and credit derivatives
Capital
Structure Arbitrage can be implemented using Equity Derivatives. Deterioration
in a company’s credit worthiness is often an indicative future decline in the
firm’s equity stock price. Theoretically, the derivative market should take
cognizance of this movement in the credit derivative market. In Real time, the
equity markets either over react or under react to these shocks in the credit
derivative markets. In those times, the strategy to be used are companies whose
equity prices have over reacted, a call should be brought and companies whose
equity prices have under reacted, a put should be brought .
Most
of the capital structure arbitrager uses a model to gauge the value left in a
CDS after considering the price of the equity or vice versa. Most of the models
used to calculate the spread are variants of the Merton Model.
One
of the studies done at University of Massachusetts, February 2004 on Capital
Structure Arbitrage strategies suggest that “Results indicate that the strategy
does not work in a predictable manner at the firm level but does quite well at
the aggregate portfolio level”. This is one of the fastest growing strategies
to get adopted. Most of the losses on this strategy are because of short
history of this strategy, lack of academic literature and practical expertise
of executing such trades on the same.
In
future, there would be more innovative instruments that would get developed
around debt and equity. Development of such instruments and research in this
area would enable the arbitrager to execute such strategy with a higher degree
of effectiveness.
