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 -

1. Set-up trades between the debt and equity of a company
2. Play between senior debt and junior securities 
3. 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.