As the Covid-19 pandemic continues to strike countries around the world, hedge funds are preparing for a host of debt restructurings in emerging economies.
Zambia’s struggle with its international creditors over debt payments is the latest sign of the stress to come. Last week, a group of 14 hedge fund and traditional bond investors indicated they would not support a proposal by the debt-laden country to suspend debt interest payments, unless it provided more clarity over its debts and came to the negotiating table.
With a stake effectively big enough to block Zambia’s plans, the funds are set up for a lengthy fight. Similar wrangles lie ahead. Debt deals in Ecuador and Argentina this year are likely to be the first among many, as the economic damage from coronavirus starts to expose countries that took on too much borrowing.
For these nations, the restructurings are painful. But hedge funds are seeking trading opportunities.
Such situations inevitably evoke memories of US hedge fund Elliott Management’s $2.4bn payday in 2016. That was the culmination of an epic and bruising 15-year battle with the government of Argentina, which finally agreed a deal to pay the remaining hedge fund holdouts. And, in 2012, Greece performed a surprise, last-minute U-turn and paid out €435m to hedge funds that had bought its debt at knockdown prices and then rejected a restructuring.
Activity such as this can be highly controversial, but hedge funds argue they are buyers of debt when others have dumped it. Debt restructurings tend to suit hedge funds, which look to buy into such situations cheaply, knowing that problems exist, and are prepared to do the intense research required.
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“There’s typically money to be made and work to be done. Bonds typically trade cheaply into a restructuring,” said one senior hedge fund executive.
Even beaten-down Venezuela has its fans despite debt trading at just 8 cents of its face value. Lee Robinson, founder of Altana Wealth and former co-founder of Trafalgar Asset Managers, this summer launched a fund to invest in the debt, telling investors in a letter that “the upside is the best we’ve ever seen for a sovereign debt restructuring”.
Some managers have also spotted opportunities in EM equities. Interest in EMs, led by the Bric countries — Brazil, Russia, India and China — soared in the mid-noughties. But as the US stock market’s decade-long rally took hold after the financial crisis, interest waned. Since the start of 2011, EM-focused hedge funds were hit by net outflows in seven out of nine years, according to data group eVestment. But this year, funds have received a net $3.4bn in flows, even as investors have pulled money out of hedge funds overall.
Robeco noted that while US stocks were above their long-term average valuations, it had upgraded its return forecasts for EMs, which were trading at below-average valuations.
“There is renewed interest in emerging markets, given that some more developed markets and economies are going to be struggling for a while” with the economic damage from Covid-19, said Sanjiv Bhatia, who manages Pembroke Emerging Markets hedge fund.
Performance is promising. EM hedge funds, which lost money in 2014, 2015 and 2018, are up 3.3 per cent this year, according to data group HFR, ahead of the hedge fund industry average of 1.8 per cent.
Making money is Pharo, one of the biggest players with about $12bn in assets. It has gained about 4 per cent in its main funds, according to numbers sent to investors, while Greg Coffey’s Kirkoswald has made double-digit gains. Mr Bhatia’s Pembroke has gained 8 to 9 per cent.
However, while opportunities may abound, risks lurk. Unlike in the Greek debt crisis, hedge funds are not able to benefit from banks dumping bonds at distressed prices. In Zambia’s case, the unknown scale and nature of debts owed to China add significantly to the risks. Argentina’s bonds have already fallen in price after a restructuring barely a month ago on concerns about the country’s economic health.
More immediately, EMs remain inextricably linked to what happens in next month’s US presidential election. Should Joe Biden win and the Democrats secure control of the House of Representatives, many investors expect a weaker dollar and a lift for EMs. But a drawn-out, disputed election would be far messier. In a stampede out of riskier assets and a rush for the safe haven dollar, the bull case for EMs is likely to be overlooked.
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