Editor’s Letter – Issue 144

October 2019

Hamlin Lovell
Originally published in the October 2019 issue

Somewhere between USD12 and USD17 trillion of debt (the number has fluctuated over the past few months) now has negative yields, and this is not only sovereign debt in the Eurozone – now including some issues from Greece, Denmark, Sweden, Switzerland and Japan. Negative yields also apply to some asset backed securities such as Danish mortgage bonds; investment grade corporate debt and a handful of high yield issues. Individuals and hedge fund managers are also sometimes being charged negative interest rates to hold cash in Euros, Swiss Francs, SEK, DKK or JPY.

How are hedge fund managers and institutional investors responding? There are broadly two approaches that can be availed of by hedge funds that have access to the right financing methods, instruments and counterparties.

One is to construct relative value, leveraged, or cross currency trades that can extract a positive return even though one or more legs of the trade has negative yields. The other is to simply avoid negative yielding debt, and seek out positive returns, often involving some degree of complexity and or illiquidity premia.

A relative value trade going short of say, German government debt and long of Portuguese or Italian government debt might be able to pick up some spread between the two. In effect, the German debt is being used as a source of funding. Similarly, if managers can obtain leverage, for instance via repos, at interest rates even lower than those on the assets they buy, it is possible to extract a positive spread, which can be multiplied through use of leverage. This is not without risk however; witness overnight USD repo rates spiking up to around 10% in September.

Another approach is to take advantage of dislocations in cross currency basis markets. In theory, the cost of hedging between two currencies should be very close to the interest rate differential between them. This theory presumes that sufficient capital exists to eliminate arbitrage opportunities. In practice, this is not always the case, which creates some arbitrage opportunities. For instance, buying negative yielding Japanese Government debt and hedging it back to USD can generate a higher return than buying US Treasuries.

For those investors who cannot use leverage or take currency risk there are other options. The vast majority of high yield corporate debt still has a positive yield and so do corporate loans, where the reference interest rates have often been floored at zero or above. Structured credit such as CLOs continue to offer some degree of yield pickup, which is often interpreted as both an illiquidity and a complexity premium. Complexity premia can also be garnered from strategies such as factoring – buying invoices or receivables at a discount – and forfaiting or trade finance. Trade finance can avoid currency risk as it is mainly USD denominated. And alternative credit strategies such as direct lending could offer a larger illiquidity premium, both for shorter term strategies such as bridge lending and those with a multi-year time frame. It is no surprise that asset raising has been buoyant in direct lending, which does raise fears of yield compression, but in relative terms a high single digit yield for well collateralized lending, bound by strict covenants, could be very attractive.