The fund ran into difficulty when a fall in natural gas prices moved against a series of positions built up by the fund’s Calgary-based energy trader, Brian Hunter. Abundant reserves, a benign hurricane season and expectations of a mild winter were all factors behind the price falls, which resulted in an estimated €4bn loss for Amaranth.
In an attempt to meet its obligations, Amaranth quietly started to sell off a large chunk of its leveraged loans and some high-yield bonds from Thursday, September 14. By the next day, the trickle had turned into a flood, with hits on a number of off-market bids alerting traders across the market to Amaranth’s distress.
The bulk of the loan trading was handled by JP Morgan, Citigroup and Goldman Sachs, which are thought to be providers of prime brokerage services to Amaranth. Some trades also went through houses such as Deutsche Bank, Lehman Brothers and Morgan Stanley, each of which provided liquidity in deals that they had previously run in primary. The haul represented about half of Amaranth’s total holding in European leveraged loans, comprising names including New Look, Lucite, Manchester United, Numericable, Mechachrome, Debitel and TI Automotive. The mix reflects a fairly typical pattern for a hedge fund, which tend to be attracted to less liquid or sub-par loans as they usually offer higher yields and increased volatility, and thereby more opportunities for profit.
Remarkably, the average move in these names was less than a point, with most trading back to pre-sell-off levels within a few days of the main event. The additional supply has been absorbed by a range of investors including other hedge funds, CLO/CDOs and the street.
“There was a huge amount of interest. Most of the trading was tight to the market, there was no huge discount,” said one loan trader who was close to the action.
Much of the paper was funnelled quickly into the CLO warehousing operations of some of the larger trading houses, and while overhangs are rumoured to remain at some dealer accounts, it is expected to be a fairly simple matter to allow the paper to trickle into the market over time, thus preventing indigestion on any of the names involved.
That is not to say that Amaranth escaped without a bloody nose. The fund is rumoured to have held a relatively large position in Numericable – around €120m – which it could only trade out of in a 96-1/2 context versus the recent 98–98-1/2 market. The blow will have been ameliorated somewhat by Amaranth’s having picked up the paper around the 98 mark.
The market’s unflinching response makes tangible the liquidity currently powering the European leveraged loans space.
“The market has taken this in its stride”, said one leveraged trader at a large investment bank. “There are those who see the market as hot and frothy at the moment, but this shows that the interest is real. It’s not just talk.”
The selldown’s relatively smooth run demonstrates how much the market has matured over the last few years as an array of new investors have joined it. Moreover, the appetite of other hedge funds to absorb supply points to the relative health that comes with a diverse investor base, countering suggestions that hedge funds are guilty of a herd mentality that can lead to them all being positioned the same way.
Moreover, with over half a billion euros of additional liquidity hitting the market every month from new structured vehicles, the market is now able to take down deals and situations it would have struggled with as recently as a year ago, and which would have been impossible three years ago.
One of the most striking developments has been the change in demand for subordinated assets, such as mezzanine. Despite the fact that mezzanine issuance is seven times higher than it was five years ago, it seems that the level of demand has been far outstripping supply, as evidenced by the mean reduction in yields from around 12% three years ago to around 9% today.
While the Amaranth situation may provide a handy benchmark for the explosion in liquidity, however, it also demonstrates how the changing nature of the investor base is affecting the role of the loan trader. Although loan trading is itself a relatively young discipline, it has grown out of a market that has hitherto been relatively insulated from external shocks due to the seniority of the asset class and the historical take-and-hold, credit-centric approach espoused by most lenders.
Subsequently, traders are far more concerned with the individual credit stories of the borrowers whose loans they trade than with seeking to identify correlations between related markets, something that high-yield bond traders are highly attuned to given their market’s high correlation with the equity and equity futures markets. In this case, however, the trading opportunity stemmed from Amaranth’s activities in a market that has a low correlation with the loan product.
Before consigning the Amaranth episode to history as a non-event, however, it is worth considering the longer term effects it could have on overall liquidity. The coming weeks will see far-reaching discussions taking place between hedge funds and the banks that provide them with leverage.
Funds that fail to convince their lenders that their risk management practices are sufficiently disciplined to prevent a similar situation could find their lending terms becoming significantly less favourable. If so, it will be interesting to see if the reduced potential to generate returns will allow the loan market to remain as attractive a destination for hedge fund money.