Corporate Bond Selling: The Sequel

Financial markets have a way of producing the same sort of short-term amnesia that vexed the quivering miscreant in Clint Eastwood's classic Dirty Harry: With all of the excitement, sometimes we just lose count.

The hiccup in the corporate credit market this past spring associated with the difficulties of the automotive sector in general and General Motors(GM Quote) in particular was one of those moments. The downgrades in Ford(F Quote) and General Motors bonds, the politics and confusion amongst rating agencies and bond index managers as to what mandated an issuer's removal from investment-grade to high-yield indices, and then finally Kirk Kerkorian's over-the-market tender offer for General Motors all contributed to a difficult situation.

By the end of it all, the automakers' bonds were oversold. A few venturesome high-yield managers gobbled them up and lived to tell the tale. At that point, the mechanics of indexation then kicked in: Once the few early risk-takers in the high-yield world started to beat the index, everyone else had to pile in to maintain benchmark performance. The bonds were bid higher. By mid-June, the yield on the GM 8.375% bond due in 2033 returned to mid-March levels and the stock was more than $5 over Kerkorian's tender price.

Indexation makes smart people do stupid things. It also beats most forms of active management. You are left to contemplate the metaphysical implications for yourself.

Insured Risk

The topic of credit default swaps was addressed here in April and again in May. A credit default swap is really nothing more than an insurance contract written by a dealer to a bond investor that pays the bond at par in the event of default. Stock investors may conceive of them as put options on the bonds. ...