Tuesday, November 11, 2008

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


Roger McIntosh said...

Hi John
There is a difference between managers who buy foreign currency bonds and swap all the cashflows and buying foreign currecy bonds and hedge the market value out of a forward date (say 1month) and roll

I run global bond funds fully hedged to AUD but stick to investment grade assets. You're right about the wide bid/offer spread on assets and and it has been tough, but not impossible to manage an orderly sell of the assets to fund the hedge losses.

Pimco - along with many other managers - I believe has real problems as they hold large parts of their portfolios in completely illiquid securitised or high yield assets, so when the margins come calling (bank counterparties for their swaps would have to require a CSA for long dated derivative transactions to hedge cashflows) even though their foreign currency asset is worth more, they're screwed as they would haveno means to sell assets to post collateral. Similarly if they rolled a monthly currency hedge - they'll struggle to sell the asset to fund the loss

Have you seen the return of their global bond fund for the month ended 30/9/08? down 7.5% for the month and 700 odd basis points behind me .. October has not fared much better for them

John Hempton said...

Thanks Roger

I had heard but not seen. I was thinking more of the funds that were inputs to various insurance portfolios.

I have some idea how large the margin calls are collectively...

Send me an email - and congrs on being nearly flat in such an environment.


Anonymous said...

John, I am an American investor who is long FAX, Aberdeen Asia-Pacific Income fund, which is mostly AUD and NZD government bonds. Are you saying that AUD gov bonds are illiquid, too? Or just AUD corporates?

John Hempton said...

No - the govies are OK and there are not many of them in Australia. The NZ government is a little (ok a lot) less fiscally sound. But still OK.

The corporates are illiquid.

John Hempton said...

I am beginning to get emails about dead bodies. Not many - I thought the email would be alive. Most of them are pointing to "other people".


thedrugsdon'twork said...

What would be the implications if a country unpegged itself to the dollar - presumably for inflation reasons?

Are there venezalian\bahrain companies that pay bonds in Dollars who may suddenly need to set up swap lines if the dollar then started to rally? They then may find they can’t access swap lines?

I thought it might make an interesting article. The dollar volatility must be hurting pegged currency. There must be companies who haven’t properly mitigated for unpegging?

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