Libor Zombies Pit Hedge Funds Against Banks in High-Stakes Feud

One of the most lucrative, and contentious, trades of 2023 has emerged in an obscure corner of financial markets, minting overnight profits for the hedge fund crowd of as much as 35%.

(Bloomberg) — One of the most lucrative, and contentious, trades of 2023 has emerged in an obscure corner of financial markets, minting overnight profits for the hedge fund crowd of as much as 35%.

The play: Load up on 1980s-era bank bonds and other securities at rock-bottom prices, and then demand early repayment at full value.

The key to the trade is that the instruments, worth about $20 billion in all, are pegged to the now-defunct London interbank offered rate, or Libor. What’s more, given how old they are, they don’t clearly stipulate how to handle interest payments in a post-Libor world. And this, as the hedge fund traders and other money managers see it, should allow them to collect the full principal amount at once. To that end, they’ve rejected virtually every effort by financial institutions to move away from the dead rate. 

Some banks, namely Barclays Plc, HSBC Holdings Plc and Standard Chartered Plc, have already chosen to repay the securities, even if it means handing windfall gains to investors. Others, however, including high-profile names like BNP Paribas SA and Rothschild & Co., have yet to relent. The securities — an arcane type of regulatory capital that no longer serve their original purpose — remain a source of low-cost financing they don’t want to give up. And to them, their good-faith offers to peg the interest payments to a new benchmark should be enough to appease creditors.

“Bondholders are trying to strong-arm issuers into getting rid of them,” said Romain Miginiac, head of research at Atlanticomnium SA, which has managed assets for GAM Investments since the mid-1980s.

This feud is, to the surprise of some observers, one of the few aspects of the transition away from Libor — once the benchmark for nearly $400 trillion of assets — that has caused trouble. But for those on both sides of the dispute, the stakes are rising. There’s just over a year until a stopgap alternative to Libor expires, at which point, some market observers say, the debt will fall into legal limbo. 

Representatives for Barclays and Standard Chartered declined to comment. Spokespeople at HSBC, BNP and Rothschild did not respond to requests for comment.

The strategy itself isn’t new. Some money managers have been building positions in discounted perpetuals (known as discos) and preference shares for years, anticipating they would eventually be called given regulatory changes post financial crisis that prevented banks from counting the funds as part of their core capital.

But recently the trade — which works best with dollar-denominated instruments sold by non-US financial institutions as a result of state and federal legislation intended to head off legal battles over Libor’s end — has attracted renewed attention. Many view the requirement to switch from the reference rate as just the leverage needed to finally get financial institutions to redeem the debt, market watchers say.

Man Group Plc, the world’s largest publicly traded hedge fund manager, is one of the firms that’s piled into the bonds. 

“We saw an opportunity to buy in March when the entire subordinated market was under pressure and offered an opportunity for significant capital appreciation,” said Sriram Reddy, managing director of credit at Man GLG. “There is a variety of structures that don’t look attractive for banks as they’ve lost regulatory recognition.”

He declined to comment on whether he’s taken part in any votes to move the legacy instruments away from Libor.

Still, there’s no doubt that money managers have increasingly been flexing their muscle when it comes to pushing banks and insurance companies to redeem the debt.

In July, holders of $200 million of Rothschild notes voted against a proposal to change the reference rate underpinning the securities. A few weeks later, an attempt by BNP to amend a similar bond’s terms also failed.

“It’s the banks’ responsibility to change the terms of these instruments by redeeming and reissuing,” said Luke Hickmore, an investment director at Abrdn, noting that the firm hasn’t boosted its position in the securities in recent months. “It’s better for our clients to stay in Libor and get to negotiate with the banks to replace the bonds.”

Disco Demand

Much better, as a matter of fact.

Legacy capital bonds were quoted at an average of about 73.6 cents on the dollar at the beginning of the year, according to data complied by Bloomberg. When called, the issuer agrees to buy them back at face value, or 100 cents, fueling gains that can amount to hundreds of millions of dollars.

While a steady climb in the price of discos over the past few months has eaten into some of the potential returns, much of the debt still trades well below par, the data show.

For some, however, the risk may not be worth the reward.

It took years — and a formal investor action group replete with legal advisers — to convince HSBC to call the debt.

Standard Chartered, despite calling its discos, has yet to redeem preference shares even after a vote to shift from Libor failed in January.

And Norway’s DNB Bank ASA has said it has no plans to buy back about $565 million of disco notes that still trade at about 80 cents. The bank has scheduled a creditor meeting to approve a new reference rate for Aug. 24.

DNB said via email that should the resolution fail, its debt may revert to a fixed rate once the stopgap benchmark, a synthetic version of Libor, expires in September 2024.

Industry observers say such an outcome could be challenged in court, exposing all involved to unwanted reputational damage in addition to hefty legal fees.

“It’s a very dangerous game — if an investor seeks to invest in a Libor denominated instrument in anticipation that it may be redeemed early and increase its market value, there is every possibility that an early redemption may not be able to take place,” said Alex Campbell, a partner in the structured finance and derivatives group at law firm Fieldfisher. “They may end up holding a bond with no fallbacks at all and where interest can’t be calculated.”

Another risk is that global regulators intervene, either via legislative fixes or other means, such as extending synthetic Libor, according to Gennadiy Goldberg, head of US rates strategy at TD Securities.

“This is the part of the market that fell through the cracks,” said Goldberg. “It’s like Y2K. Most of the issues were taken care of, but we found a couple of computers in the back room that nobody thought about. Banks are having to clean this up.”

–With assistance from Paul Cohen.

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