BlueBay Asset Management one of the UKs leading specialist fixed income managers was forced to close down its long-short emerging markets fund yesterday (Thursday) after shedding 53% of its value, highlighting how deleveraging and volatile credit spreads are savaging fixed income investments in risk markets.
The $1.2bn emerging market Total Return Fund accounts for 6% of BlueBays $20.6bn of assets under management. Its co-manager Simon Treacher has resigned "after a breach of internal valuation policy," the company said with its shares falling by as much as 37.5% following the news. David Dowsett, the funds co-manager will stay and look after the long-only portfolio and remain until the long-short fund becomes fully liquidated. Neither BlueBay nor Treacher could be reached for comment.
No further details on Treachers breach of the companys valuation policies are available. "The breach was recent, limited and resulted in no material impact on the NAV [net asset value] of the fund, or of any other funds managed by the company," BlueBay said.
"The company would like to stress that there is no connection between the breach concerned and either the recent losses incurred on the fund or the intention to wind the fund down," it added.
Each fund is required to mark-to-market their positions on a daily basis as a means to update the current value of assets under management. This is usually executed by a fund analyst but in these volatile and illiquid conditions, bid/offer quotes for the same asset can be at wildly different levels while prices on Bloomberg screens are often completely absent, say analysts.
As a result, portfolio managers are increasingly relied upon to determine the tradable value for illiquid instruments for over-the counter transactions in emerging market and high yield paper. "When you have so many positions that you need to mark on a daily basis like BlueBay has and when traders have all but disappeared, there is a lot of subjectivity in these trades and the fund manager runs into a whole host of difficulties," said one emerging markets investment banker.
Treacher has been a star performer and is a popular figure in the investor community. "He is the most well known emerging markets investor in the UK," one debt syndicate manager in London proclaimed.
Gurjit Kambo, an analyst at Numis Securities who tracks the companys performance, believes that his departure may have inflicted significant reputational damage on BlueBays emerging markets franchise. The closure of the fund may also hit flows into the firms other funds. Treacher joined BlueBay in July 2001. Before this, he spent three years at Moore Capital where he headed the emerging market operations and seven years at Morgan Grenfell (later Deutsche) Asset Management where he was a board director with responsibility for emerging markets.
The fund pursued a long cash bond/short credit default swap strategy, revealed Kambo. It began to plummet in October and November after its CDS exposures began to tighten sharply. Since the summer, some fund managers have bet that as US interest rates come down, there should be tightening in cash bonds reflecting the tightening spread on the US benchmark. As the market continues to price in risks for further defaults, the spread between the CDS and the cash bond should widen, or so the theory goes. However, there has been tightening of credit protection on bets the fund has shorted. Treacher is known to be a diversified but yield-hungry risk taker snapping up credits from Russian corporate paper to Ecuadorian debt in recent years where spreads on cash bonds have widened sharply from historic lows in 2006 and pre-August 2007.
In addition, Kambo at Numis Securities speculates that the Total Return Fund may have had exposure to sovereign credit protection for Latin and Asian countries that have benefited from recent Western policy efforts to boost international liquidity. In October, the Federal Reserve and IMF announced the provision of dollar credit lines to central banks in systemically important emerging economies boosting their sovereign creditworthiness. For example, top quality credits such as Brazil, Mexico and Colombia now trade as much as 400bp inside Russia five year CDS.
The relative value strategy fund is also rumoured to have large holdings of credit protection for Kazakh sovereign and financial institution paper, which have tightened on the back of the governments capital injections into the banking system. This has eased concerns over the difficulties of refinancing needs of Kazakh bank that have sizeable stock of short term foreign currency debt. Markets have responded favourably to the move with the sovereign five year CDS now trading 150bp inside Russia.
Analysts say the long cash bond and short credit default swap asset allocation is a tried and tested relative value tactic that has made big profits in the bull-run for emerging market assets. But as EM bank franchises wind down and financial institutions face capital allocation constraints, playing the credit default swap market for an EM investor is full of hazards. "The CDS market is dead," said Ian McCall, an emerging markets fund manager at Argo Capital Management in London, which has around $1bn in assets. "With your hedge provider going bankrupt and just a few traders left for some stuff like Russian corporate protection, the illiquidity is providing dealers with an opportunity to screw you over. They charge above the bid/offer rate since no one is concerned about their franchise anymore only if they have a job tomorrow." McCall now refuses to participate in new credit default swap trades as part of a shorting strategy and vows to go long-only in bonds.
Given the precipitous drop in the Treacher co-managed BlueBay hedge fund during September and October as long/short bets went horribly wrong, analysts say investors would most likely have made redemption requests. The difficulties of unwinding large illiquid CDS positions may have contributed to the decision to close the fund rather than ride through the volatility. It is not clear if the liquidations of assets will be managed gradually or a firesale will be on the cards, which would inflict further volatility on secondary markets. An investor close to BlueBays holdings says it is likely Kazakh sovereign as well as corporate CDS will tighten as the fund supplies the market with much needed protection.
The emerging market investor community has also been rocked this week by the departure of Christian Deseglise, the promotional head of HSBCs Global Asset Managements funds business. As global equity markets tumbled in the third quarter, HSBCs EM assets under management have dropped from $93bn to $67bn, or 28% between December 31 and September 30, mirroring the 37% decline of the MSCI World Index. Sylvia Coutinho, regional head of Latin America, will succeed Deseglise.