Friday13 March 2020 ★ FINANCIAL TIMES 19
MARKETS & INVESTING
J O N AT H A N W H E AT L E Y
Foreign investors’ selling of emerging
market stocks and bonds since the
onset of the coronavirus outbreak has
dwarfed the EM disposals at the start of
the global financial crisis, highlighting
the strength of risk aversion among
global fund managers.
Foreign investors have sold $41.7bn of
EM stocks and bonds since global mar-
kets woke up to the Covid-19 outbreak
on January 21, according to the Institute
of International Finance. That was dou-
ble the amount of outflows in the same
51-day period after September 8, 2008.
“It is a very large number,” said Robin
Brooks, chief economist at the IIF. “This
means another big tightening in finan-
cial conditions for emerging markets
because that’s what outflows are, a
sudden stop.”
Most of the outflows have been from
equities rather than bonds as investors
fear that companies in emerging econo-
mies will be hit particularly hard in the
global slowdown expected this year.
Before the outbreak, Mr Brooks and
colleagues at the IIF had warned that
many emerging economies had fallen
into secular stagnation as they struggled
to find new drivers of growth after the
fall in global commodity prices from
2013.
Covid-19 has hit such economies at a
time of weakness, Mr Brooks said.
“There have been so many bumps in the
road in recent years for EMs that the
urge to run to safety is so much greater
this time around.”
EM stocks and currencies have fallen
steeply along with risk assets in devel-
oped markets since the start of the out-
break. But EM sovereign and corporatebonds initially fell only slightly in rela-
tion to developed market bonds, giving
them a previously unaccustomed status
as haven assets.
Analysts said efforts by central banks
and governments to control inflation
and reduce currency volatility had
made investors willing to take the
“carry” from higher interest rates on
EM bonds and reduced their aversion to
EM risk.
The IIF’s data show that foreign inves-
tors increased their exposure to EM
bonds during the first month of the out-
break. But those flows have reversed
since the end of February and bond
prices have fallen in the past few days.
Sovereign EM bonds in the bench-
mark JPMorgan EMBI Global Diversi-
fied index rose 1.7 per cent in value from
January 21 to March 4 but have since
fallen 5.2 per cent.
The IIF monitors cross-border flows
from emerging markets that supply
data on a daily basis, which it says
capture 80-90 per cent of the investible
universe. Its data do not capture flows
into and out of mutual funds or
exchange traded funds that entail no
cross-border transactions.Cross asset
Global investors dump $42bn of EM
stocks and bonds since late January
J O E R E N N I S O NEmergency cash-conservation meas-
ures taken byOccidental Petroleum
and other energy companies may not
be enough to stave off credit rating
downgrades, S&P Global has warned.The rating agency said it was ready to
take rapid action as it takes stock of the
damage ofcoronavirus nd the oil pricea
war between Saudi Arabia and Russia.
On Wednesday, the agency said it was
reviewing its assessments of energy
groups after a severe sell-off across mar-
kets that raised doubts about their abil-
ity to service and refinance their debts.
Michael Grande, a senior director,
said the agency would not hesitate to
respond if credit quality deteriorated.
“We are not going to be as patient as we
were before,” he said, referring to trou-
ble in energy markets five years ago.
In a call with investors, Thomas Wat-
ters, a managing director at S&P Global,
listedOccidental,Devon Energy nda
Hess Corporation mong companiesa
that could lose “investment grade”
ratings of triple B and above.
Final decisions had not yet been made
in the review, which S&P hoped to com-plete by the end of the month, he said.
“We are not definitively saying that
any of these credits are going to slip out
of investment grade,” said Mr Watters.
“Merely we are highlighting that cur-
rently these are some of the credits that
relative to their peers have higher debt
leverage, maybe weaker credit ratios or
a weaker hedge book. It’s a possibility.”
Triple B rated Occidental, which last
year boughtAnadarko n a $55bn deal,icut its dividend on Tuesday for the first
time since 1991 as it prepared for a
prolonged price slump.
“Its debt leverage is a bit rich maybe
for the rating,” Mr Watters said.
Companies rated below investment
grade, known as junk, could be in line
for “multiple notch downgrades” with
large volumes of debt coming due soon.
Energy groups have been squeezed by
a big drop in demandbecause of thevirus outbreak. Talks to cut oil produc-
tion and to support prices broke down
last week after Russia balked at a deal
with some of the biggest oil-producing
nations.
Saudi Arabia plans to boost output to
put pressure on Moscow — an act that
has sent prices into a tailspin and dealt a
severe blow to the US shale oil industry.
Borrowing costs for junk-rated energy
companies in the US have hit their high-
est levels since January 2016 when a
series of defaults ricocheted through the
market after an oil price plunge.
Mr Grande, in charge of midstream
energy groups and refiners, and Mr
Watters, who looks after upstream com-
panies and oilfield services, doubt com-
panies will be able to depend on sales of
assets or access to capital markets to
raise cash in the near term. It leaves
fewer options than five years ago.
“Capital markets were a lot more
accepting than they are now,” said Mr
Watters. “As part of our analysis this
time around, if issuers are planning to
issue equity, which we deem to be
unlikely, or sell assets, given the current
environment, we will be a lot more scep-
tical and probably have less patience.”Commodities
Energy groups warned rapid action will
be taken on credit rating downgrades
‘We are not going
to be as patient as
we were before’Michael Grande, S&P GlobalThe coronavirus outbreak has led to
dramatic outflows from EM nationsFastFT
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C O L BY S M I T H— NEW YORK
Investors and analysts are warning
about deepening cracks in the world’s
largest government bond market.
Strange patterns have started to
emerge such as drops in the price of US
Treasuries — a traditional haven — even
as riskier assets such as stocks have been
squeezed by fears that the coronavirus
outbreak will spark global recession.
Some are warning that the patterns
could lead to the unwinding of one of the
market’s most popular trading strate-
gies — with potentially serious conse-
quences. Such fears prompted the US
Federal Reserve to announce a sweeping
package of measures yesterday to try to
ease conditions, including pumping
trillions into the financial system.
How did we get here?
Nervous banks and other dealers seek-
ing to insulate themselves from swings
in asset prices have pulled back from
facilitating trades between investors.
The US Treasury market is normally a
safe place for investors to shelter from
sell-offs but it has not been able to
escape the onslaught of volatility.
This has made it more expensive for
investors to buy and sell Treasuries as
dealers have retreated.
Who is at risk?
The deteriorating trading conditions
have put particular pressure on relative
value traders. Such traders seek to profit
from small price discrepancies between
two assets that are nearly identical.
Hedge funds likeMillennium Man-
agement,ExodusPoint,Alphadyne nda
Capula re among the most activea
operators in this area. One common
trade is to buy cash Treasuries and sell
interest rate futures. Cash bonds tend to
trade slightly more cheaply than equiv-
alent derivatives because they carry a
higher capital charge for banks.
This means that, in normal condi-
tions, investors can buy Treasuries, sell
the futures contract and pocket the
difference. Recently, however, this trade
has started to come undone.What has changed?
The decline in liquidity in cash Treasur-
ies has been more severe than in the
futures market. This has resulted in a
widening of the price difference
between the two assets with cash Treas-
uries falling relative to futures.
This might seem confusing, given the
Treasury market has rallied sharply in
recent weeks as investors have flocked
to the safety of government bonds. But
the cash market has not rallied as much
as futures.
The result is that the value of the cash
Treasuries held by relative value traders
has dropped in comparison to the valueof the futures they sold. As these losses
become more severe, traders could be
forced to give up on their positions,
dumping Treasuries into an already
dysfunctional market.
“I am massively worried that institu-
tions are panicking and are unwinding
positions at will,” said Tom di Galoma, a
managing director at Seaport Global
Holdings, an investment bank.What could happen next?
On Wednesday afternoon in New York,
some traders became nervous after they
saw signs of heavy selling in so-called
off-the-run Treasuries, which are older
issues of benchmark bonds that tend to
be cheaper to buy and harder to sell.
This fanned concerns that relative
value hedge funds could be starting to
suffer under the strain of the market’s
volatility. If that continues, expect
Treasury prices to drop.How big is this trade?
It is hard to calculate precisely but the
growth of the “repo” market — where
hedge funds obtain short-term cashloans in exchange for Treasuries to juice
their trades — is a good barometer, said
Mark Cabana, an interest rate strategist
at Bank of America.
Daily volumes in the overnight repo
market have roughly doubled over the
past five years to over $1tn, according to
the Federal Reserve Bank of New York.
The growth of the trading strategy
also caught theeye of regulators astl
year after a cash crunch sent repo
borrowing costs soaring in September.
The Bank for International Settle-
ments thenwarned hat highly lever-t
aged relative value trading strategies
may have exacerbated the situation.What can be done about it?
The Fed moved to address the problem
yesterday, ramping up the amount of
cash it will inject into the repo market
for the third time this week to ensure
funding markets are functioning.
The US central bank also said it would
alter the types of bonds it will buy in
order to address what it called “highly
unusual disruptions in Treasury financ-
ing markets associated with the corona-
virus outbreak”.
The move could help, said Jay Barry, a
managing director on the interest rate
strategy team at JPMorgan, but he noted
that policymakers have limited tools at
their disposal.
“There is no immediate fix that can
change it,” he said. “The only thing that
will return some semblance of normalcy
to the deepest and most liquid market in
the world is volatility decreasing.”Will it be enough?
That is the big question. Relative value
traders have been significant buyers of
US Treasuries in recent years, helping to
swallow the deluge of debt coming from
the expanding government deficit.
Investors fear that an unwinding of
these strategies could ricochet through
the entire global financial system.Unwinding of ‘relative value’
trades could exacerbate the
current sell-off, analysts warn
‘I am
massivelyworried
institutionsare
unwindingpositions
at will’Riskier assets
such as Wall
Street stocks
have been
squeezed by
virus fears
Brendan McDermid/ReutersFixed income. ealers retreatD
Cracks in US Treasuries spell
trouble for financial system
L AU R E N C E F L E TC H E R
A N D R O B E RT S M I T HA $900m hedge fund run byH2O Asset
Management uffered a large losss
during this week’s market rout in the
latest sign of rocky performance at the
London-based firm.
H2O’s Alpha 10 fund, which trades
global bonds, currencies and stocks, lost
15.8 per cent in one of its share classes on
Monday, according to numbers sent to
investors and seen by the Financial
Times.
Another share class of the fund lost
10.5 per cent that same day. Unlike most
of H2O’s funds, which are domiciled in
the EU, Alpha 10 is a Cayman Islands-
based vehicle that does not disclose its
performance publicly. The loss has not
been previously reported.
It comes as another blow to H2O,
which has disclosed hits to a number of
its Europe-based funds during the fast-
moving markets of the past few weeks.
In a letter to investors this week, it
warned of “surprisingly large” losses on
bets on the direction of bonds and
currencies. H2O declined to comment.
The asset manager is a subsidiary of
French bankNatixis, whose shares
dropped about 16 per centyesterday
after a 5 per cent fall on Wednesday.
H20 declined to comment.
On Wednesday, Paul Myners, theformer City minister, submitted a writ-
ten question to UK parliament, asking
what plans the government had to
investigate H2O’s “risk control strate-
gies and executive leadership” in light of
the disclosures.
H2O, which managed $33.9bn in
assets at the end of 2019, has been
betting against US Treasuries, which
have rallied strongly during the recent
market chaos, and betting on Italian
bonds as Rome grapples with the
world’s second-largest outbreak of coro-
navirus.
M a t t h e w C l a r k , a n a l y s t a t
Mediobanca, wrote in a note this week
that, while H2O’s funds have recovered
from losses in the past, “the severity of
the current drawdowns and, potentially,
deleveraging enforced by margin calls in
recent days would, in my view, plausibly
diminish the chances of a V-shape
recovery even should markets start to
move in favour of their positions”.
The loss means Alpha 10 is down 36.
per cent for the year in one of its share
classes and 26.1 per cent in another,
putting it on track for what would rank
as its worst year of performance by
some distance. So far, its biggest fall in a
calendar year occurred in 2016 when it
lost 2.3 per cent, according to a letter to
investors seen by the FT.
The letter, sent last month, also
showed that the Alpha 10 fund had been
adding to its bets against German Bunds
and against UK gilts. Both classes of
bond have rallied over the past month.Asset management
H2O fund
hit by large
loss during
trading rout
‘The severity of the
current drawdowns would
diminish the chancesof a V-shape recovery’
Government bond volatility has surged
MOVE index (implied one-month volatility in the Treasury market)Source: BloombergMARCH 13 2020 Section:Markets Time: 12/3/2020- 18:34 User:stephen.smith Page Name:MARKETS1, Part,Page,Edition:EUR, 19, 1