As the FT reported this morning, the voluble and prescient Hugh Hendry is shortly to close a new fund launched only a few months ago designed to profit from a China slowdown.
As has been reported elsewhere previously, Hendry’s mechanism for such a trade is part of what makes it interesting. He’s shorting China, via Japan.
The rationale is to target cyclical, industrial Japanese corporate credits — all highly exposed via exports to China, and all currently grossly mispriced for risk. Take, for example, Nippon Steel, 5yr CDS which could recently be had for a pittance at 50bps annually.
Some more detail on Mr Hendry’s rationale is worth reprising from an Eclectica investor letter of a few months back. (Mr Hendry’s flagship fund also has a short Japanese credit element):
…but first, it may require the spectacle of seeing Japan implode and so we have been actively positioning the Fund to profit from such a scenario. As many of you know, the fiscal situation in Japan is rapidly rising out of control. Government tax receipts are down 14% over the last 12 months; government spending is twice the receipts and the trade surplus appears structurally impaired. We have to go back to 1991 to find the last time they ran a primary surplus sufficient to meet their national debt’s interest payments. Today they would need the equivalent of 4.4% of GDP. Failing this, and assuming they do not shorten the debt maturity of the JGBs that they sell to the public, then the ratio of public debt to GDP is guaranteed to rise further. It is currently 196% of GDP with the IMF estimating that it will rise to 234% by 2014.
This situation has not gone unnoticed. The sovereign dollar default swap has doubled to 75bps since August, and Japan is now the most expensive credit to insure against a dollar default in the G10. However, we have been active buyers of corporate debt default swaps. We find it remarkable that one can insure highly leveraged utilities at 23bps despite their considerable yen debt. Consider the Tokyo Electric Power Co. (9501 JP) with a market capitalisation of $32bn and net debt of $81bn. The debt is 7x EBITDA, the interest cover is 1.9x, and the average interest cost for now is thankfully just 1.9% p.a.
The Japanese government has been sensible in one area; two thirds of all their JGB issuance has been in maturities of ten years or more whereas the US has a skew to shorter dated issuance. However, it is probable that the public sector in Japan is crowding out the private sector from the long end, for whilst only 24% of the government debt is of 2-5 year maturity, the corresponding figure for the utility company is 57%. Furthermore, they are dependent on 70% of their debt being sourced from non-banking sources, i.e., from the market place. Clearly there are two prominent risks: debt rollover and higher interest rates. The “cheap” risk is a normalisation of interest rates brought about by a dearth of buyers at these levels. Should Tokyo Electric’s interest cost double to 4.6%, the company’s EBITDA-less-CAPEX would just cover the interest bill. What cost would credit underwriters insist for the CDS in this scenario?
We have a notional exposure representing almost 40% of the Fund’s NAV. It represents a large notional risk exposure with a quantifiable and manageable downside loss of just 9 bps of the Fund’s NAV every year for five years. However, the potential return to the Fund in the event of a default would be 23% of NAV, or 250x our annual outlay. Whilst we would still make 1% point of NAV should it trade in line with the sovereign credit risk, or 10x our annual cost. We might get rich but we certainly will not die tryin’.
Related links:
www.ft.com/hedgefunds
www.twitter.com/samgadjones