An anonymous partner at a mid-sized London hedge fund expressed something I was trying to say a couple of weeks ago fair better than I could have. From the Financial Times:
"A lot of managers have gone from being long-short funds [funds that make bullish and bearish bets on stocks] to being long-long funds with leverage, which removes the whole point of hedge funds offering protection in the event of a downturn," said a partner at a mid-size hedge fund in London.
I expressed my argument somewhat less elegantly – saying that that some hedge funds were not really hedged. And many of my readers pointed out — quite correctly – that no one that is fully hedged makes money.
But what I was getting at was that it was quite costly to hedge say a long position in an emerging market equity market with an offsetting short position in the same equity market. Funds that hedged in the same market didn't do as well as funds that did not hedge. Until May, a rising tide was lifting all boats. And punishing shorts.
So there was a temptation to become a long/ long fund.
Or to find proxy hedges that didn’t cost you an arm and a leg.
The one that I am most familiar with comes not from emerging market equity markets, but from the market for the local currency debt of emerging economies.
It went like this:
Buy the local currency debt of an emerging economy with a high coupon.
Don’t hedge the currency risk. That cost you.
Instead buy insurance against the risk that the country would default on its foreign currency denominated debt. That meant holding a credit default swap – i.e. buying credit insurance.
This trade isn’t a secret. Joanna Chung, quoting Mohammed Grimeh in the FT:
Mohammed Grimeh, global head of emerging market trading at Lehman Brothers, said: “Over the last few months, as credit spreads tightened, hedge funds have been moving to illiquid local instruments that offer a higher risk and reward but they are also buying CDS protection against overall country risk.”
The IMF also discussed it in its most recent financial market update (see footnote 4 on page 9).
It isn’t hard to see the logic of the trade. Turkey was paying a 12% coupon – maybe a bit more – on its local currency debt at the beginning of the year. Insurance against a default on Turkey’s dollar bonds cost maybe 200 basis points.
You were hedged … sort of. And the whole trade had a nice carry. A real nice carry. After all, you were holding a rather overvalued currency and needed some compensation for the risk.
It was a long/ short trade, not a long/ long with leverage trade. But the long was on local currency debt and the short was on external foreign currency debt.
The hedge even has worked in Turkey. Sort of. A contract insuring against the risk of default on Turkey’s foreign currency debt is worth a lot more now than it was in January. Unfortunately, both the Turkish lira and Turkish lira bonds are worth a lot less now than they were then too.
Still, it has struck me that there was something a bit strange with the trade.
It worked in a backward looking sense. In the past, indebted countries often had lots of local currency and foreign currency debt. So when a country’s currency has declined and the value of its local currency bonds fell, the value of the country’s foreign currency bonds also fell. Credit spreads rose. So the value of a contract providing insurance against default rose.
It actually worked in another sense. In times of huge distress, the local currency debt of some countries is arguably less risky than the foreign currency debt. Countries like Argentina defaulted on their foreign currency debt but honored their local currency debt. So in a really bad scenario, it arguably made sense to be long the local currency stuff and short the foreign currency bonds. Never mind that Russia did the opposite of Argentina, defaulting on its local currency bonds and honoring its Russian era Eurobonds.
Incidentally, the other trade that works in backward looking stress tests is “long the external bonds of Argentine corporates, short the external bonds government of Argentina.” Both firms and the government defaulted. But you did better in the restructuring holding the bonds of the Telcos than the government …
So why do I say that there was something strange about the hedge? Simple:
The hedge implicitly assumes that correlations that held in the past would hold in the future, even though conditions change.
And in this case, two conditions were changing:
First the scale of foreigner’s local currency exposure was growing, big time. That changes the country’s incentives.
And second the amount of sovereign foreign currency debt was falling, big time. Still is. Chris Mewbourne of Pimco thinks repayments will top new issuance this year. So the stock of external debt is falling absolutely, not just relative to sovereign reserves. That is why insurance against the risk of default is cheap.
At the limit, a country might not even have any external debt left to default on. Or just a trivial amount.
But a bank could still sell insurance against external default. Why not? The risk is low. And nothing prevents the folks from selling more insurance than there are bonds. Delphi showed us that. Selling insurance (off the balance sheet) is another way to get an easy yield pickup.
And folks holding local currency debt could still buy insurance against default on non-existent foreign currency debt as a hedge.
The backward-looking correlations work. And why worry too much about the possibility that the conditions that gave rise to those correlations have changed?
Sorry about an obscure post. I am sure that my tendency to delve into this kind of thing (and ferret out obscure reserve data) is one reason why this blog isn’t always an easy read.
But the operation of the sovereign debt market is one of my long-standing interests.
As are market dynamics under stress.
I suspect that a lot of folks scrambled to find hedges for previously unhedged positions over the past two months — and to shore up their proxy hedges. But I am reading market tea leaves, not speaking from direct knowledge.
And I do still wonder about the robustness of some of the hedging strategies used by players in the credit markets of advanced economies in truly adverse conditions …