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Delphi Punishes Hedge Funds

Most are said to have preferred a long bet on the company's bonds.



bankruptcy filing might make it Black Monday for the auto parts industry, but for hedge funds with big bets riding on the company's stock and bonds, the picture could be even bleaker.

The No. 1 parts supplier to

General Motors

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ended months of frenetic speculation on Saturday by seeking Chapter 11 bankruptcy protection. The stock, which could well end up worthless in a reorganization, was recently trading for 48 cents after falling from $2.20 to $1.12 on Friday.

For so-called "event-driven" hedge funds that tailor their bets to news flow, bankruptcy was not the preferred outcome. Faced with the choice of shorting the stock and owning Delphi's bonds, or doing the reverse, many funds did the former, according to sources who spoke to

. At this point, that trade has rendered the greater pain.

"I don't know why they were long the bond. It's because they're crazy," said John Taylor, who runs FX Concepts, a macro and futures hedge fund. "It's exactly the same thing as a year ago with General Motors and


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, when everybody was betting they were not going to be junk."

As if to remind traders of that botched tactic, Standard & Poor's on Monday downgraded General Motors further into junk status, cutting its long-term corporate credit rating to BB- from BB.

"The downgrade follows Delphi Corp.'s bankruptcy filing, repercussions of which could impede GM's efforts to turn around its ailing North American automotive operations," S&P said.

Up until early Friday, bonds of Delphi were trading around $60 to $65.50 per $100 of face value -- high levels for a company that could go bankrupt. But the assumption of many was precisely that Delphi would avoid bankruptcy.

By Friday, amid leaks that the United Auto Workers union wasn't going along with Delphi's requested concessions, Delphi bond prices started to fall. "They wanted to take their compensation package, including benefits, down from $63 to $18 an hour. They would never have agreed to that," says Kevin Tynan, an auto analyst with Argus Research.

With the Treasury market closed Monday for Columbus Day, the impact on bond prices remains uncertain. In over-the-counter trading, the 6.55% Delphi bond due 2006 fell 12%, as its price fell to $58 per $100 of face value from $65.

To be fair, the Delphi story was an event-driven manager's dream. Hedge funds that exist to make bets on company news virtually had to jump on the Delphi story. And if someone had to take a stance on Delphi, buying the bond and shorting the stock seemed prudent, considering the superior positioning of bondholders to stockholders in a Chapter 11 proceeding.

"They wanted to move up the food chain," says Tynan.

Bobby Richardson, a hedge fund manager who runs Argent Financial Group, a convertible hedge fund, said the risk was well-considered: "I suppose that people who were trading the bond did some recovery analysis," he says, referring to a calculus that tries to foretell how much of a bond's value will be recoverable under bankruptcy. (Richardson noted that Delphi had no convertible paper outstanding.)

Optimism, or an excess of it, is probably what drove many hedge funds or even traders to go long the bond. "Frankly, everybody was blindfolded because the result of a bankruptcy was so negative for everybody -- except maybe for Delphi -- that people were long the position," says Tynan. "Bonds got a lot cheaper, so hedge funds started to buy," says Taylor "They thought things were going to be OK. In the auto sector, panic is perhaps the best alternative. But that's not the way most hedge funds work," he says.

From his macro-strategist perspective, the trade did not make sense because of the still-low rate environment. "Low interest rates mean that spreads are tight and that there is less room for error. Owning the Delphi bonds does not give you much room for profit," he says.

So what's next? "GM is hurt immensely by this," says Tynan. "It affects the entire industry." Shares of General Motors fell almost 8% to $26.14, the decline exacerbated by S&P's downgrade.

Tynan adds that other small auto part suppliers that depend on Delphi will suffer as well. "If Delphi owes you money as a supplier, if for instance you only get 10% out of a $10 million transaction: that hurts. You may have to file yourself," he says.

However, Tynan notes, "there is a lot of bearishness regarding this industry and the market, to some extent has already priced in." In the meantime, Delphi will have to restructure its costs and it could take a year to a year and a half for this company to do so, this analyst says.