Unhedged Funds?

Brad Setser worries about the degree to which hedge funds speculating in emerging market debt are really hedged:

Roubini Global Economics (RGE) Monitor: Levered long/ long funds: 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....

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... 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... 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."...

It isn't hard to see the logic.... Turkey was paying a 12% coupon... 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.... [T]he 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... both the Turkish lira and Turkish lira bonds are worth a lot less now than they were then too.... [W]hy 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 foreigners' 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.... [N]othing 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....

The backward-looking correlations work. And why worry too much about the possibility that the conditions that gave rise to those correlations have changed?... 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...