Similarly, the debt markets seem to be aware that there are no guarantees that those bets will pay off. The price of credit default swaps on Citi -- protection against the company reneging on its debt -- hit new records on Thursday, according to Bloomberg, with investors paying $525,000 a year to protect $10 million of debt against default.
The scramble to cover short positions and get ahead of other equity holders has fueled huge swings in penny stocks like Citi and AIG (AIG - Get Report) as well as those of other high-profile firms where investors smell trouble ahead, like GM, Bank of America and Wells Fargo. For instance, a volatility measure for Citi stock was almost twice as high in mid-February as the average daily reading over the past year.
A catalyst for upticks in shares of troubled companies can be something as simple as an overall market bounce, or the passage of a government initiative that benefits financial institutions, like a change in accounting rules. Both of those factors are incredibly unpredictable, as are the debt markets.
But if hedge fund managers are lucky, it can be a lucrative bet -- reaping rewards of 11% to 20% on the difference between common and preferred shares, according to the hedge fund manager who discussed the trade."The institutions have been eating this trade up," the hedge fund manager says.