Getting your duration and diversification offshore – how bond market crises and currency crises intertwine

It helps if you read the post about international diversification first.  If you do not understand the problem of owning foreign equities and hedging back into your own currency by the end read my further explanation in the comments.

That said – once you have eaten your spinach – I will show you a really nasty problem that some small country bond funds have.

An equity portfolio doesn’t have to be very diversified to get most the benefits of diversification – twenty well chosen stocks will give you most of the benefit.  A bond portfolio requires considerably more diversification primarily because of the asymmetrical nature of bond performance – in a twenty stock portfolio one stock that does much worse than the index is likely to be offset by one that does better.  With a bond portfolio a bad bond doesn’t have an offset except the spread on good ones. 

Anyway in small countries if you want to run a diversified bond portfolio you generally have to go offshore – the local country seldom carries enough diversified names. 

Issuers know this – and issue regularly in lots of little currencies.  Lots of American companies for instance had Australian bond programs (Kangaroo bonds) because the local managers wanted diversification.  The American company would then would change the money back into USD and protect their currency risk with currency swaps.

Alternatively local bond managers regularly purchased bonds offshore and used derivatives to protect themselves from currency risk.

This process is common.  Even American bond managers buy foreign currency bonds and protect themselves from currency movements with currency derivatives.  This extract from a 2004 Pimco Investment Outlook is a case in point.  Bill Gross is suggesting that to the extent that Pimco wants duration it should look offshore (Bunds, Gilts even) and (presumably) swap the currency back into USD. 

[The solution to the inflation risk in the US] is to be rather choosy about the country where you hold your duration, to reduce it in reflating countries (U.S., Japan) and increase it in relatively vigilant ones (Euroland, U.K.). In so doing, the potential pain from holding bonds in a reflating global environment can be reduced if not anesthetized entirely. 

Now put yourself in the position of the Australian bond fund manager who has massively diversified their bonds globally – and has covered their currency risk by entering contracts to buy AUD at a fixed exchange rate (say parity to the USD) at some stage in the future.  The AUD – as anyone who lives here knows – has had a rough trot lately – falling over 30 percent quite rapidly. 

The currency hedges are either margined or one or three month rolls.  Either way you are going to have to come up with about 30 percent of the offshore portfolio in cash as that is what you have lost on the currency hedges. 

Presumably of course you have made an offsetting amount by owning bonds in a foreign currency that has appreciated. 

This of course presumes that you can sell the bonds.

Which is a problem. 

As everyone should have noticed by now bond markets are not exactly liquid.  A lot of bonds are 90 offered, 20 bid but with a real value that might be 95.  Most are better than that - but if you have to sell billions in bonds you have a problem.

The real value is irrelevant – my Australian fund manager (which could be a life insurance company and hence implicitly levered) has a problem – they need the liquidity.

They can get the liquidity by selling Australian bonds – which infects the Australian market with the contagious selling/no buyers that foreign markets have.  But somewhere they need to sell.  Big time.

Well I can see a few life insurance companies (which are levered entities) in small countries having big problems.  It wouldn’t do to mention names …

As for Australian bond managers – they have a rather nasty habit of imploding – see Basis Capital or Absolute Capital Management for an example.  These were levered sellers of volatility – the name of Basis Capital told most the story. 

That said – even the surviving Aussie bond managers are having a rough time.  Very rough.

There is a lot in the relationship between currency and crises.  Much I do not understand and much I don’t grok. 

As for Bill Gross: Pimco hardly looks like the disastrous Australian bond funds.  It is not levered for a start (and that makes a world of difference).  It is mostly in US agency and GSE mortgage backed securities anyway.  And besides the US – unlike Australia – is not a small country.  But the strategy that Pimco employed (own foreign assets swap out of the currency) is widespread.  And in a US currency crisis (if such a thing ever happens) the runs on funds that use that strategy could be large.  It’s a potential issue.

But I am an Australian – and unfortunately I know the truth – this is far more likely to hurt us than the United States.

 

 

John Hempton

Naked Capitalism on AIG

 Yves (Naked Capitalism) does an admirable job picking apart the latest AIG story.  

My original calculations on the AIG bailout are being blown out of the water.  I just wonder however what this does to AIG bonds.  The minus side is obvious - AIG is much worse than it appeared in advance.

The plus side for the bonds is that the government is turning much of its injection into preference shares - and that means the Government injection is subordinate to the bonds.  That logically increases the value of AIG bonds.  

Net-net it is probably a wash - but I have not thought through the details enough.

J

Follow up:  The bonds are well dealt with in this post.

Weekend edition: things that get easier and harder every year

It gets easier every year to read bank balance sheets.  I get a lot of practice and it is not aerobic.  And this is despite the acrobatics banks perform in their accounting.

But on the weekend I did something that gets harder each year – the annual proficiency test to be a volunteer surf lifesaver at Bronte Surf Lifesaving Club. 

Also I took a rescue board for a long paddle with my 8 year old lying on the front.  Not a great sight…

More work required!

A Krona Problem

There is a New York Times story about what is going on in Iceland – and one thing jarred me – the quoted exchange rate.  They quoted 130 to the dollar which suggests the Krona has only lost half its value. 

This seems a little mild compared given what has happened to the country – it has effectively defaulted on international deposit insurance obligations and had the IMF step in.

But the Central Bank of Iceland gives an exchange rate – and the exchange rate matches the New York Times story.  The NYT however says that the banks are rationing foreign currency – which suggests that the published exchange rate is a nonsense.  Still the IMF money can be supporting an exchange rate - I really do not know.  

Anyway here is the sequence of Krona per Euro exchange rates as published by Sedlibank. 

9/15/2008	129.64	130.36	130.0
9/16/2008	130.15	130.87	130.51
9/17/2008	131.13	131.87	131.5
9/18/2008	135.32	136.08	135.7
9/19/2008	131.29	132.03	131.66
9/22/2008	130.05	130.77	130.41
9/23/2008	138.03	138.81	138.42
9/24/2008	139.32	140.1	139.71
9/25/2008	135.8	136.56	136.18
9/26/2008	140.72	141.5	141.11
9/29/2008	142.45	143.25	142.85
9/30/2008	145.08	145.9	145.49
10/01/2008	152.62	153.48	153.05
10/02/2008	154.39	155.25	154.82
10/03/2008	155.65	156.53	156.09
10/06/2008	154.91	155.77	155.34
10/07/2008	135.83	136.59	136.21
10/08/2008	172.16	173.12	172.64
10/09/2008	143.87	144.67	144.27
10/10/2008	149.74	150.58	150.16
10/13/2008	149.79	150.63	150.21
10/14/2008	149.96	150.8	150.38
10/15/2008	149.58	150.42	150.0
10/16/2008	150.08	150.92	150.5
10/17/2008	150.58	151.42	151.0
10/20/2008	150.08	150.92	150.5
10/21/2008	150.08	150.92	150.5
10/22/2008	150.08	150.92	150.5
10/23/2008	150.58	151.42	151.0
10/24/2008	151.58	152.42	152.0
10/27/2008	151.58	152.42	152.0
10/28/2008	152.07	152.93	152.5
10/29/2008	152.07	152.93	152.5
10/30/2008	152.57	153.43	153.0
10/31/2008	153.07	153.93	153.5
11/03/2008	159.55	160.45	160.0
11/04/2008	163.54	164.46	164.0
11/05/2008	163.54	164.46	164.0
11/06/2008	165.54	166.46	166.0
11/07/2008	165.54	166.46	166.0

I have highlighted the day of full collapse.  There is a Bloomberg article from the crisis day which quotes the Krona trading at 350 to the Euro – way worse than the official exchange rate. 

In most developing countries a black market develops pretty quickly in foreign currency when this sort of thing happens.  Often the street rates are way different from official rates.  [You want a big difference – go to Burma…]

Are the Icelandic people so law abiding they have not developed a street market or is the official rate real? 

What is meant by banks rationing foreign currency?  The New York Times doesn't give an answer.  Can someone with real experience in trading in Iceland post crisis (or someone from Iceland give me an answer).  I am surprised at the data.

If the Krona finds a freely convertible level at about the level quoted in the NYT then Iceland will not go through the extent of crisis I originally thought.  And if it is freely convertible whoever purchased Krona at 350 to the Euro on the day of the crisis made a fabulous trade.  Find that trader!

 

 

John Hempton

PS - Some follow up.

I found a good end-of-October internet post about the situation.  The rationing of foreign currency is indeed severe and the exchange rates are hence meaningless.  I would love to know the extent of the rationing and whether a black market has developed in the currency.   If people wish to add to or correct material here I would appreciate it.

Anyway here is the post material:

 Iceland situation

---

I've not written anything about the situation in Iceland for just over a week now. Here is the latest from my perspective as an Icelander.


- The Central Bank lowered interest rates last week from 15,5% to 12%. However, because of agreement with the IMF before the weekend, interest rates were raised to 18% today.
This means companies and individuals, that are already struggling to pay loans, will suffer even more. No new loans at all from anywhere.

- The IMF agreement last week gives us $2.1 billion to prop up our currency. This is not enough, and we're seeking an extra $4 billion from other countries, the Fed, ECB and Scandinavian CB's.

- It is estimated that economic contraction will be around 10%.

- It is estimated that 20% of companies will not be able to pay payroll this month. I have a feeling a lot of companies are just "ghost" companies, people still working, but the company is essentially bankrupt.

- Massive layoffs in the construction industry, and the banking sector of course.

- Inflation roared to 15,5% this month, expected to rise.

- Our currency is still worthless and still not traded overseas. Although there was a news today that hinted there was some trade with the ISK, where it was less than half the value that our CB claims.

- I must note that there are no shortages (yet) of food, fuel and medicine, or much else I've noticed. But if current situation continues then we could see some shortages, but not of necessities. However, because of rationing of foreign currency other importers are not able to import new supply of e.g. clothes, industry material etc. I expect many companies not being able to continue their operations because of import restrictions.

- The sovereign state has not yet defaulted on any loans, despite statements in the foreign media. It requires a lot of help to get back on it's feet, and seems to be getting it soon.

- A lot of families are "stuck" in their homes, cannot sell, cannot move, cannot buy. The mortgage debt is around 10-40% higher then the value of their homes. Home value is expected to drop significantly in the coming months.

- The government owns all the banks, and indirectly owns all the media, and all the debt of the people. With taxes and debt payment the people are in a state of servitude to the government. Not many realize this.

- Some conspiracy theories are on the icelandic forums that the government is censoring the media, directing them to mitigate the news. They own all the media after all!

- Many are considering strategies out of this, e.g. husband and wife divorcing and allowing one of them to default on the debt and go bankrupt, while the other one keeps a clean slate. Some are thinking about fleeing to another country.

- The government has been able to offer a temporary freeze on payments on mortgages, 4-6 months. The depression is expected to last at least 1 year, maybe 2 years.

- There are some protests, but they seem to be minor. There is general calm, but still anxiety, frustration, over the situation. I expect things to get a lot worse when people lose their jobs and have nothing better to do than to protest.


I think the coming friday/monday is the big reveal moment, e.g. who pays the payroll and who doesn't. Just then we'll realize how serious the situation is. I expect thousands to lose their jobs.


How does once a free-market capitalist system, with the highest standard of living in the world, the most freedom of the press in the world, the happiest people in the world and least corrupt people in the world turn into a Orwellian fantasy almost overnight is beyond me.

Global diversification – an Australian perspective

There is a post by Dennis P. Quinn   Hans-Joachim Voth – good Finance professors both of them – on why international diversification does not seem to deliver the benefits that were expected.  They argue that globalisation has made everything more correlated. 

I think they are spectacularly wrong.

Obviously the good Professors are not Icelandic.  Iceland really has almost totally melted down – and if you were Icelandic but have global assets you have done just fine thank you very much.  In Kroner you might be up 500 percent even if your foreign assets were not that good.  Having an even small percentage of your wealth diversified globally has saved your sorry and cold Icelandic backside…

I enjoy all those mathematical models that suggest that if it is correlated it is not diversified.  But day-to-day correlation is not where it is at.  What you really want is “uncorrelated in a crisis”.  International diversification is pretty good at that.  Iceland has had a crisis – but New Zealand for instance – a country often paired with Iceland looks OK for now.

Now I am going to give you an Australian perspective.  Felix Salmon points us to a Merrill Lynch report that suggests on measures like current account deficit, short term funding requirements etc (all the things that obsess me) that Australia is the riskiest country in the world.  Latvia obviously is not a country according to Merrill Lynch – but they are more or less right.  Australia really is risky.  It has an American style spending habit, a property boom that allows me to go to Sausalito and think the houses are inexpensive (they are compared to Bronte).  And it has an economy highly dependent on a small number of commodity exports.  (Iron ore and China looks like a risk to me.) 

In other words Australia could do an Iceland.  I don’t think it will – Australia has a few advantages which include a government that has fiscal credibility and very low debt levels, a banking system that is relatively small to GDP (at least compared to Iceland), and the minerals that China needs (and will need more of one day). 

But Australia is not riskless.  The risks whilst small are very real.  And if you are a well-to-do Australian and you are not diversified at least 20 percent globally you are doing yourself no favours.  Those with self-managed superannuation funds should pay heed.

If you are an Australian and you diversify globally but swap the currency back to Australian dollars (as one well known retail fund manager does) you are also failing to diversify.  The main advantage of diversification internationally is that it removes the country specific catastrophe risk and swapping the currency back is simply insane.  Indeed an Australian retail international fund that wants to swap all the currency back is putting marketing ahead of client asset protection and is – in my view – almost criminally negligent.  Just think how an Icelandic international fund would look if it had swapped its currency exposure back to Kroner!  They would be a wipe-out because they would have to sell their valuable international assets to meet their obligations to deliver valuable foreign currency for worthless Kroner. 

But what is good for an Icelandic person or an Australian (some global diversification fully accepting currency risk) is good for an American too.  The US is bigger and more stable than Iceland or even Australia – but it is not riskless.  There remains a small chance that somehow the US will become a fascist dictatorship.  The chance I suspect is smaller after last Tuesday – and might be vanishingly small anyway – but it is not zero.  There are plenty of things that can go wrong. 

And there is a small chance that the US could go to pot in ways that I can’t envisage.  And in that case international positions would not be entirely correlated.  The US might take some of Europe down with it – but China and Australia might be OK.  A little international diversification would be great for Americans too.

The dear Professors have this wrong.  International stocks are correlated but not entirely and not in extrema.  Rich people in small Latin American countries know this.  Maybe the good Professors should too.

 

 

John Hempton