Archive for March, 2010
FX, the Carry Trade, and Arbitrage Vigilantes
What do you think of the Euro? How about the Japanese yen? Are you expecting the Thai baht to depreciate in value versus the Brazilian real? Speculators, central banks, corporations, governments, financial institutions, and other constituencies ask similar types of questions every day. The largely over-the-counter global foreign exchange markets (no central exchange) are ubiquitous, measuring in the trillions – the BIS (Bank for International Settlements) computed the value of traditional foreign exchange markets at $3.2 trillion in April 2007. Thanks to globalization, these numbers are poised to expand even further. Like other futures markets (think oil, gold, or pork bellies), traders can speculate on the direction of one currency versus another. Alternatively, investors and businesses around the world can use currency futures to hedge (protect) or facilitate international trade.
Without getting lost in the minutiae of foreign exchange currency trading, I think it’s helpful to step back and realize regardless of strategy, currency, interest rate, inflation, peg-ratio, deficits, sovereign debt, or other factor, money will eventually migrate to where it is treated best in the long-run. When it comes to currencies, it’s my fundamental belief that economies control their currency destinies based on the collective monetary, fiscal, and political decisions made by each country. If those decisions are determined imprudent by financial market participants, countries open themselves up to speculators and investors exploiting those decisions for profits.
Currency Trading Ice Cream Style
As mentioned previously, currency trading is predominantly conducted over-the-counter, outside an exchange, but there are almost more trading flavors than ice cream choices at Baskin-Robbins. For instance, one can trade currencies by using futures, options, swaps, exchange traded funds (ETFs), or trading on the spot or forward contract markets. Each flavor has its own unique trading aspects, including the all-important amount of leverage employed.
The Carry Trade
Similar to other investment strategies (for example real estate), if profit can be made by betting on the direction of currencies, then why not enhance those returns by adding leverage (debt). A simple example of a carry trade can illustrate how debt is capable of boosting returns. Suppose hedge fund XYZ wants to borrow (sell U.S. dollars) at 0.25% and buy the Swedish krona currency so they can invest that currency in 5.00% Swedish government bonds. Presumably, the hedge fund will eventually realize the spread of +4.75% (5.00% – 0.25%) and with 10x leverage (borrowings) the amplified return could reach +47.5%, assuming the relationship between the U.S. dollar and krona does not change (a significant assumption).
Positive absolute returns can draw large pools of capital and can amplify volatility when a specific trade is unwound. For example, in recent years, the carry trade from borrowing Japanese yen and investing in the Icelandic krona eventually led to a sharp unwinding in the krona currency positions when the Icelandic economy collapsed in 2008. High currency values make exports less competitive and more expensive, thereby dampening GDP (Gross Domestic Product) growth. On the flip side, higher currency values make imported goods and services that much more affordable – a positive factor for consumers. Adding complexity to foreign exchange markets are the countries, like China, that artificially inflate or depress currencies by “pegging” their currency value to a foreign currency (like the U.S. dollar).
Soros & Arbitrage Vigilantes
Hedge funds, proprietary trading desks, speculators and other foreign exchange participants continually comb the globe for dislocations and discrepancies to take advantage of. Traders are constantly on the look out for arbitraging opportunities (simultaneously selling the weakest and buying the strongest). Famous Quantum hedge fund manager, George Soros, took advantage of weak U.K. economy in 1992 when he spent $10 billion in bet against the British pound (see other Soros article). The Bank of England fought hard to defend the value of the pound in an attempt to maintain a pegged value against a basket of European currencies, but in the end, because of the weak financial condition of the British economy, Soros came out victorious with an estimated $1 billion in profits from his bold bet.
I’m not sure whether the debate over speculator involvement in currency collapses can be resolved? What I do know is the healthier economies making prudent monetary, fiscal, and political decisions will be more resilient in protecting themselves from arbitrage vigilantes.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at time of publishing had no direct position on any security referenced. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Digging a Debt Hole
Little did I know when I signed up for a recent “distressed” debt summit (see previous article) that a federal official and state treasurer would be presenting as keynote speakers? After all, this conference was supposed to be catering to those professionals interested in high risk securities. Technically, California and the U.S. government are not classified as distressed yet, but nonetheless government heavy-hitters Matthew Rutherford (Deputy Assistant Secretary, Federal Finance at the U.S. Department of Treasury), and Bill Lockyer (Treasurer for the State of California) shared their perspectives on government debt and associated economic factors.
Why have government officials present at a distressed debt conference? After questioning a few organizers and attendees, I was relieved to discover the keynote speaker selections were made more as a function as a sign of challenging economic times, rather than to panic participants toward debt default expectations. As it turns out, the conference organizers packaged three separate conferences into one event – presumably for cost efficiencies (Distressed Investments Summit + Public Funds Summit + California Municipal Finance Conference).
The U.S. Treasury Balancing Act
Effectively operating as the country’s piggy bank, the Treasury has a very complex job of constantly filling the bank to meet our country’s expenditures. Deputy Assistant Secretary Matthew Rutherford launched the event by speaking to domestic debt levels and deficits along with some the global economic trends impacting the U.S.
- Task at Hand: Rutherford spoke to the Treasury’s three main goals as part of its debt management strategy, which includes: 1) Cash management (to pay the government bills); 2) Attempt to secure low cost financing; and 3) Promote efficient markets. With more than a few hundred auctions held each year, the Treasury manages an extremely difficult balancing act.
- Debt Limit Increased: The recent $1.9 trillion ballooning in the U.S. debt ceiling to $14.3 trillion gives the Treasury some flexibility in meeting the country’s near-term funding needs. The Treasury expects to raise another $1.5 trillion in debt in 2010 (from $1.3 trillion in ’09) to fund our government initiatives, but that number is expected to decline to $1.0 – $1.1 trillion in 2011.
- Funding Trillions at 0.16%: Thanks to abnormally low interest rates, an investor shift to short-term safety (liquidity), and a temporary rush to the dollar, the U.S. Treasury was able to finance their borrowing needs at a mere 16 basis points. Clearly, servicing the U.S.’ massive debt load at these extremely attractive rates is not sustainable forever, and the Treasury is doing its best to move out on the yield curve (extend auctions to lengthier maturities) to lock in lower rates and limit the government’s funding risk should short-term rates spike.
- Chinese Demand Not Waning: Contrary to recent TIC (Treasury International Capital) data that showed Japan jumping to the #1 spot of U.S. treasury holders, Rutherford firmly asserted that China remains at the top by a significant margin of $140 billion, if you adjust certain appropriate benchmarks. He believes foreign ownership at over 50% (June 2009) remains healthy and steady despite our country’s fiscal problems.
- TIPS Demand on the Rise: Appetite for Treasury Inflation Protection Securities is on the rise, therefore the Treasury has its eye on expanding its TIP offerings into longer maturities, just last week they handled their first 3-year TIPS auction.
There is no “CA” in Greece
State of California Treasurer Bill Lockyer did not sugarcoat California’s fiscal problems, but he was quick to defend some of the comparisons made between Greece and California. First of all, California’s budget deficit represents less than 1% of the state’s GDP (Gross Domestic Product) versus 13% for Greece. Greece’s accumulated debt stands at 109% of GDP – for California debt only represents 4% of the state’s GDP. What’s more, since 1800 Greece has arguably been in default more than not, where as California has never in its history defaulted on an obligation.
The current California picture isn’t pretty though. This year’s fiscal budget deficit is estimated at $6 billion, leaping to $12 billion next year, and soaring to $20 billion per year longer term.
Legislative political bickering is at the core of the problem due to the constitutional inflexibility of a 2/3 majority vote requirement to get state laws passed. The vast bulk of states require a simple majority vote (> than 50%) – California holds the unique super-majority honor with only Arkansas and Rhode Island. Beyond mitigating partisan bickering, Lockyer made it clear no real progress would be made in budget cuts until core expenditures like education, healthcare, and prisons are attacked.
On the subject of bloatedness, depending on how you define government spending per capita, California ranks #2 or #4 lowest out of all states. Economies of scale help in a state representing 13% of the U.S.’ GDP, but Lockyer acknowledged the state could just be less fat than the other inefficient states.
Lockyer also tried to defend the state’s 10.5% blended tax rate (versus the national median of 9.8%), saying the disparity is not as severe as characterized by the media. He even implied there could be a little room to creep that rate upwards.
Finishing on an upbeat note, Lockyer recognized the January state revenues came in above expectations, but did not concede victory until a multi-month trend is established.
After filtering through several days of meetings regarding debt, you quickly realize how the debt culture (see D-E-B-T article), thanks to cheap money, led to a glut across federal governments, state governments, corporations, and consumers. Hopefully we have learned our lesson, and we are ready to climb out of this self created hole…before we get buried alive with risky debt.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds (including CMF and TIP), but at time of publishing had no direct position on any security referenced. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Getting Distressed can be a Beach
It was just another 65 degree winter day on the sunny shores of Huntington Beach at the 2nd Annual Distressed Investment Summit (March 1st through 3rd) when I entered the conference premises. Before digging into the minutiae of the distressed markets, a broad set of industry experts spoke to a diverse crowd including, pension fund managers, consultants, and hedge fund managers at the Hyatt Regency Huntington Beach Resort and Spa. The tone was somewhat restrained given the gargantuan price rebounds and tightening spreads (the premium paid on credit instruments above government securities) in the credit markets, nonetheless the tenor was fairly upbeat thanks to opportunities emanating from the still larger than average historical spreads.
Topics varied, but several speakers gave their views on the financial crisis, macroeconomic outlooks, general debt/credit trends, and areas of distressed credit opportunity. Like investors across all asset classes, many professionals tried to put the puzzle pieces together over the last few years, in order to provide a clearer outlook for the future of distressed markets. To put the addressable market in context, James Perry, Conference Chair and Investment Officer at the San Bernadino County Employees Retirement Association, described the opportunity set as a $2.5 trillion non-investment grade market, with $250-$400 billion in less liquid securities. Typically distressed securities consist of investments like bonds, bank debt, and/or CLOs (collateralized loan obligations), which frequently carry CCC or lower ratings from agencies such as Standard & Poors, Moodys, and Fitch.
As mentioned previously, since the audience came from a diverse set of constituencies, a broad set of topics and themes were presented:
- Beta Bounce is Gone: The collapse of debt prices and massive widening of debt spreads in 2008 and 2009 have improved dramatically over the last twelve months, meaning the low hanging fruit has already been picked for the most part. Last year was the finest hour for distressed investors because price dislocations caused by factors such as forced selling, technical idiosyncracies, and credit downgrades created a large host of compelling prospects. For many companies, long-term business fundamentals were little changed by the liquidity crunch. As anecdotal evidence for the death of the beta bounce, one speaker observed CLOs trading at 30-35 cents during the March 2009 lows. Those same CLOs are now trading at about 80 cents. Simple math tells us, by definition, there is less upside to par (the bond principal value = 100 cents on dollar).
- Distressed Defaults: Default rates are expected to rise in the coming months and years because of record credit issuance in the 2006-2007 timeframe. The glut of questionable buy-outs completed at the peak of the financial markets driven by private equity and other entities has created a sizeable inventory of debt that has a higher than average chance of becoming distressed. One panel member explained that CCC credit ratings experience a 40% default within 5 years, meaning the worst is ahead of us. The artificially depressed 4-7% current default rates are now expected to rise, but below the 12% default rate encountered in 2009.
- Wall of Maturities: Although the outlook for distressed investments look pretty attractive for the next few years, a majority of professionals speaking on the topic felt a wave of $1 trillion in maturities would roll through the market in the 2012-2014, leading to the escalating default rates mentioned above. CLOs related to many of the previously mentioned ill-timed buyouts will be a significant component of the pending debt wall. Whether the banks will bite the bullet and allow borrowers to extend maturities is still an open topic of debate.
- Mid Market Sweet Spot: Larger profitable companies are having little trouble tapping the financial markets to access capital at reasonable rates. With limited capital made available for middle market companies, there are plenty of opportunistic investments to sift through. With the banks generally hoarding capital and not lending, distressed debt investments are currently offering yields in the mid-to-high teens. Borrowers are effectively beggars, so they cannot be choosers. The investor, on the other hand, is currently in a much stronger position to negotiate first lien secured positions on the debt, which allows a “Plan B,” if the underlying company defaults. Theoretically, investors defaulting into an ownership position can potentially generate higher returns due forced restructuring and management of company operations. Of course, managing the day-to-day operations of many companies is much easier said than done.
- Is Diversification Dead? This question is relevant to all investors but was primarily directed at the fiduciaries responsible for managing and overseeing pension funds. The simultaneous collapse of prices across asset classes during the financial crisis has professionals in a tizzy. Several diversification attacks were directed at David Swensen’s strategy (see Super Swensen article) implemented at Yale’s endowment. Although Swensen’s approach covered a broad swath of alternative investments, the strategy was attacked as merely diversified across illiquid equity asset classes – not a good place to be at the beginning of 2008 and 2009. The basic rebuttal to the “diversification is dead mantra” came in the form of a rhetorical question: “What better alternative is there to diversification?” One other participant was quick to point out that asset allocation drives 85% of portfolio performance.
- Transparency & Regulation: In a post-Bernie Madoff world, even attending hedge fund managers conceded a certain amount of adequate transparency is necessary to make informed decisions. Understanding the strategy and where the returns are coming from is critical component of hiring and maintaining an investment manager.
- Distressed Real Estate Mixed Bag: Surprisingly, the prices and cap rates (see my article on real estate and stocks) on quality properties has not dramatically changed from a few years ago, meaning some areas of the real estate market appear to be less appealing . Better opportunities are generally more tenant specific and require a healthy dosage of creativity to make the deal economics work. Adjunct professor from Columbia University, Michael G. Clark, had a sobering view with respect to the residential real estate market home ownership rates, which he continues to see declining from a peak of 70% to 62% (currently 67%) over time. Clark sees a slow digestion process occurring in the housing market as banks use improved profits to shore up reserves and slowly bleed off toxic assets. He believes job security/mobility, financing, and immigration demographics are a few reasons we will witness a large increase in renters in coming periods. Also driving home ownership down is the increased density of youngsters living at home post-graduation. Clark pointed out the 20% of 26-year olds currently living at home with their parents, a marked increase from times past.
Overall, I found the 2nd Annual Distressed Investment Summit a very informative event, especially from an equity investor’s standpoint, since many stock jocks spend very little time exploring this part of the capital structure. Devoting a few days at the IMN sponsored event taught me that life does not have to be a beach if you mix some distress with a little sun, sand, and fun.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at time of publishing had no direct position on any security referenced. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
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