Hedge funds that trade bonds and loans are increasing bets that Europe’s sovereign-debt crisis will spread to Portugal, Spain and Italy, even after Greece won a temporary reprieve with 12 billion euros in aid.
“Nothing you’ve seen so far has dealt with solvency, just liquidity,” said Simon Finch, head of credit trading at CQS UK LLP, a London-based hedge fund that oversees $11 billion.
Finch, who has bought and sold corporate bonds and loans for 18 years, has stepped up trading in mobile-phone, utility and toll-road companies in the three countries. He expects their governments will be forced to slash spending to pay off lenders, slowing growth and reducing discretionary consumer outlays.
CQS is among the hedge funds that say investors are underestimating the odds of distress or even default not only by Portugal, whose credit rating was downgraded this week to junk status by Moody’s, but also by the bigger Italy and Spain. The funds are moving beyond a direct wager that sovereign debt values will tumble, targeting potential fallout in the corporate-debt market and the banking industry.
“We are on the verge of an economic collapse which starts, let’s say, in Greece, but it could easily spread,” billionaire investor George Soros said during a panel discussion in Vienna on June 26. “The financial system remains extremely vulnerable.”
Most hedge funds had been hesitant to make big wagers against European debt ahead of the parliamentary vote in Athens last week that led to the European Union approving the aid to Greece, said Omar Kodmani, senior executive officer at London-based Permal Investment Management, a unit of Legg Mason Inc. that has invested $23 billion with hedge funds on behalf of clients.
Finance chiefs of the 17 nations that use the euro also pledged to complete work on a second rescue package that could reach 85 billion euros ($122 billion) and would involve banks rolling over 70 percent of Greek bonds maturing by mid-2014.
“Most opinions on the euro zone and Greece were not very pessimistic,” Kodmani said. “People saw it as a problem that could be postponed, so there hasn’t been much negative positioning.”
Hedge funds had been reluctant to discuss any bearish trades they made for fear of sparking protests from regulators who view the investors as vultures. On July 5, European lawmakers called for restrictions on traders’ uses of credit-default swaps to profit from failures on sovereign debt they don’t own. Credit default swaps are a type of insurance that makes investors whole if a borrower fails to pay.
Assessing Austerity’s Impact
Now that an immediate Greek default has been avoided, investors are looking for ways to play continued distress among countries including Italy, the euro area’s third-largest economy, and Spain, its fourth. The extra yield investors demand to hold Portugal’s 10-year bonds over German bunds slipped 19 basis points today to 994 basis points from a euro-era record of 1015 basis points yesterday, when Moody’s cut the country’s credit rating four levels to Ba2, below investment grade.
Italian 10-year bonds fell today, driving the spread over German bunds to the most since before the euro was introduced in 1999. The Italian yield increased more than 5 basis points to 5.175 percent, pushing the difference over bunds to 221 basis points. The spread over German bunds for Spain’s 10-year bond was 265 basis points, up from 206 basis points a year earlier. A basis point is 0.01 percentage point.
One area where Finch has been trading is the debt of mobile-phone companies, whose ability to repay bonds and loans could be diminished by austerity-triggered economic slowdowns. If such companies were downgraded, the market would be flooded with junk bonds, causing prices to fall.
“If you crimp peoples’ spending, you’ll find that phone calls are surprisingly discretionary,” Finch said.
Portugal Telecom SGPS SA, the country’s biggest telephone company, is rated one rung above junk, according to a presentation that Finch made to investors in May. In the event of a downgrade, its 5.8 billion euros of debt would equal about one-10th of this year’s forecasted issuance of 55 billion euros to 60 billion euros in non-investment-grade bonds.
Telecom Italia SpA, Italy’s biggest phone company, is rated two notches above high yield. In the event of a downgrade, it would equal half of this year’s estimated issuance, according to the presentation.
Finch is also looking at utilities and toll roads where prices charged to consumers are regulated by the government. Budget-cutting measures could keep the government from providing subsidies to corporations, which will then have to make up the gap between the cost of providing services and what people can pay for them.
“Our thesis is that the bad countries can make bad corporate debt,” he said.
Marathon Asset’s View
Marathon Asset Management LP, a $10 billion fund run by Bruce Richards, told investors in mid-June that it’s evaluating the purchase of portfolios of $1 billion or more of real estate and corporate loans from banks in Portugal, Ireland, Spain, the United Kingdom and Italy as they are forced to sell debt to raise capital, according to a presentation sent to clients.
Richards expects some countries to nationalize financial institutions and sell assets because the banks have borrowed too much money.
“The banking problem is acute throughout Europe, including the German, French and U.K. banks, which have begun to sell assets and raise capital,” Richards wrote in the 27-page presentation.
Marathon, based in New York, said it has already traded more than $1 billion gross market value of sovereign credit in the peripheral European countries this year, using both CDS and bonds.
Nick Swenson, who runs Groveland Capital LLC in Minneapolis, has been wagering on sovereign defaults in peripheral European countries since March 2010. He’s not concentrating on Portugal or Ireland. Instead his $10 million fund is buying credit-default swaps on Spanish and Italian government bonds, which are cheaper than those other countries and whose defaults would potentially cause more damage in the market.
“Italy and Spain seem to be outliers,” he said of the relatively robust prices of their CDS, which trade at 222 basis points and 307 basis points, according to data provider CMA, compared with 935 basis points for Portugal and 2,150 basis points for Greece. “People think they aren’t at risk of defaulting.”
Credit swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.
While their economies are certainly more robust than Greece’s, Italy and Spain aren’t out of the woods, Swenson said.
“The scale of their economies creates an inertia that somehow raises the probability of something bad happening,” he said.
“The need to restructure the periphery and the quite reasonable demand that bondholders take pain will, in my view, happen,” said Swenson. “It’s not a radical view and yet prices of all non-Greek bonds seem to be too optimistic.
Al Moniz, portfolio manager at Fore Research & Management LP, a New York-based hedge fund with $1.9 billion under management, said he is “very bearish” on European sovereign debt and the region’s banks, though he declined to say how he was positioning his portfolio to take advantage of that weakness.
“We are still in the early stages of the European crisis,” he said. “It hasn’t even been 30 percent played out.”