Views From the Floor - The Dollar Price Matters:
Un-distressed Debt at Distressed Prices

The Dollar Price Matters: Un-Distressed Debt at Distressed Prices

Unusual dynamics are occurring across both sovereign and corporate credits in emerging markets. There are multiple sovereign debt issuers whose debt is currently trading at very low dollar prices, with the market pricing in near certain default within a few years. But perhaps more interesting than these walking zombie cases are the numerous cases of higher spreads for large, liquid EM sovereigns, quasi-sovereigns and corporates. These are significantly less likely to default than the walking zombies, tend to be ‘fallen angels’, or may even still carry investment grade ratings from one rating agency (as is the case with a large Latin American state-owned oil company). Those with longer dated bonds (10-40 years) were until recently at or slightly above part and are now trading at around 50-60% of par, in many cases with cash coupons of 7-9%. Market pricing of shorter dated bonds and fundamental analysis suggests low probabilities of short to medium term default. With current yields in the teens, it should mean that the coupons will quickly amortise purchase price.

A further factor to weigh up is that such pricing also eliminates some duration risk and jumps to default risk. At current pricing levels, rightly or wrongly, many of these longer dated bonds are pricing in a high probability of default over a longer-term price horizon (e.g. 7-10 years). If such a default were to happen, what does it matter to an investor if they purchased the 10-year or the 40-year debt? In the event of default, longer-dated debt has the right to accelerate, and all debts become due and payable (on paper) immediately so the temporal advantage of lower duration bonds goes away. With bonds currently trading at or near likely default recovery values, these longer dated bonds at such low dollar prices offer interesting convexity and near indifference to default, certainly after taking in the likely amortisation of today’s purchase price which will take place due to the high cash coupons. These higher-spread, longer-dated bonds are not purely duration or interest rate plays due to most of the yield being the spread over the risk-free rate, unlike the cases of the large universe of low dollar priced and low spread investment grade bonds.

These dynamics are creating significant opportunities for distressed investors, who would not normally have the opportunity to buy such high-quality issuers within a distressed investing mandate. If performing debt continues to trade at distressed levels, investors who can take their eyes off developed markets may well find some attractive opportunities.

BoJ: Crisis? What Crisis?

With the Japanese yen breaching 150 to the US dollar at the time of writing, the spotlight in financial markets turn towards Japanese Government Bonds (‘JGBs’). As we can see from Figure 1, the yen is at its weakest level for 30 years, largely driven by the growing interest rate differential between itself and the dollar. This dynamic is replicated in bond markets, with the spread between JGBs and US Treasuries reaching 4%, its worst level for 20 years (Figure 2). The speed of the move has also taken markets by surprise, with the spread surging from 2.5% to around 3.9% in months rather than years as has previously been the case.

The position may well deteriorate further: Japanese CPI is only at 3%. After three decades of deflation, the Bank of Japan is unlikely to move to counter inflation without seeing the direction of wage growth. Japanese companies tend to move pay bands in April, meaning that if wages rise in line with inflation the central bank may stick with its current course. In the meantime the BoJ may well continue to make minor interventions in the currency markets to maintain the yield cap, rather than more drastic action. Without larger interventions, the selloffs may continue until morale improves. As the gilt market has shown, the bond vigilantes may push bond prices further and faster than markets, governments and central bankers expect. The wider the spread to US yields the sharper the potential reversion should the BOJ abandon the cap: both in yen and in yields.

Figure 1. USD/JPY

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Source: Bloomberg; as of 21 October 2022.

 

Figure 2. 10-Year Yield – JGBs Minus UST

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Source: Bloomberg; as of 21 October 2022.

 

A Chill Wind for Shorts

After continued selloffs, short interest correspondingly increased by around 10% on a cap-weighted basis in Q3 2022. This is largely intuitive – as markets fall, we would expect investors to short more to hedge against further falls and to align their portfolios with the directional momentum of stock markets. Indeed, cap-weighted short interest is at its highest levels since mid-2020, the trough of the post-pandemic selloff (Figure 3).

However, our models indicate that the short interest is less concentrated in the worst stocks than previously. ‘Unattractive’ stocks – which are expensive on a multiple basis, with poor earnings momentum and with low exposure to the Quality factor - are being shorted less relative to ‘attractive’ stocks than they were in June, with this being most pronounced for the Value factor and those with high informed investor activity (Figure 4).

Figure 3. Utilization – Cap Versus Equal Weighted

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Source: Bloomberg; as of 30 September 2022.

 

Figure 4. Utilization of Unattractive Minus Attractive Stocks

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Source: Bloomberg; as of 30 September 2022.

 

With contributions from: Patrick Kenney (Man GLG- Portfolio Manager), Peter van Dooijeweert (Man Solutions – Head of Multi-Asset Solutions), Dan Taylor (Man Numeric – CIO) and Eric Wu (Man Numeric – Principal, Quantitative Alpha Strategy and Integration).