Hedge funds perplexed by negative Bund yield conundrum

LONDON, Sept 3 Mon Sep 3, 2012 2:58pm IST

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LONDON, Sept 3 (Reuters) - Hedge funds are split on how to bet on German bonds, in a sign that even managers supposedly at the cutting edge of finance are struggling to work out how paper offering buyers a negative yield will fare as the euro zone's debt crisis unfolds.

Germany's two-year bond yields entered negative territory in July and currently offer minus 0.037 percent, which means investors holding onto maturity would book an automatic loss.

Some managers are using bonds or derivatives to bet these sky-high prices must fall, especially if euro zone leaders try to solve the bloc's huge debt problems by pooling debt, a move that would shift more of the debt burden onto Germany.

Others say prices are justified by market uncertainty and by the chance they will be repaid in valuable Deutschmarks if the euro zone breaks up. Some also think it is worth paying Germany simply to look after their cash because of the safety it offers.

Among managers to be shorting Bunds is Patrick Armstrong, Chief Investment Officer at Armstrong Investment Managers, who thinks debt sharing and inflation will push up yields. Shorting means betting on a lower price for a security in the future.

"We still believe the Euro mess will get resolved at some point, despite the lack of follow-through on any concrete plans from politicians to date," he told Reuters.

"Fiscal integration and some form of debt mutualisation will be required in any potential solution, so we expect Germany will be on the hook for a chunk of the periphery debt in one way or another should a positive outcome occur."

Armstrong said he went short 10-year bonds in April at around 1.7 percent and doubled the position when rates were 1.3 percent in May. It now accounts for 7 percent of his Macro fund.

Since the crisis began, investors have shifted huge sums into the debt of governments they see as low-risk, sending the prices of bonds issued by the U.S., Germany and the UK soaring. For example, the 10-year Bund yield is down from 1.84 percent at the start of the year to 1.35 percent on Monday.

"German 10-year rates are already significantly below inflation levels, and if the market returns to equilibrium (then) prices on 10-years generally are about 1 percent above levels of inflation," he said. Annual German inflation rose to 2 percent in August.

The trade echoes bets that some funds have put on France, whose bond yields are just above Germany's.

"PAIN TRADE"

The trades come amidst a testing year for so-called macro funds, which were made famous by the likes of George Soros and which bet on moves in bonds, commodities, stocks and currencies.

In the first seven months of the year these funds, which have struggled to cope with sudden market moves on the back of comments by policymakers, gained just 1.08 percent. In contrast the S&P 500 with dividends reinvested was up 11 percent.

A key issue when trading Germany has been whether a worsening of Europe's debt crisis would make investors keener on 'safe haven' assets like Bunds or mean Germany will take on more of other countries' debts, pushing up its own borrowing costs.

While bets against Bunds have attracted a number of managers, notably U.S. billionaire John Paulson, according to a Financial Times story in April, they have so far proved "a one way pain trade", says ECM fund manager Sohail Malik.

And with plenty of room for investor disappointment in September - given the expectations surrounding meetings of the European Central Bank, which may detail bond-buying plans for Spain and Italy, and the U.S. Federal Reserve - some funds are getting ready to buy Bunds again for protection.

"Most macro people I speak to are looking to buy (into) the sell-off in German bonds," said Scott Gibb, managing director for fund of funds at Cube Capital, who says funds profited from the fall in yields this year, before selling when yields hit 1.2 percent. "It's a dangerous game to be fighting trends."

Fund of funds managers, who invest in a basket of hedge funds, see the trades made by a wide range of managers.

"I'd say people are more inclined to be gearing up for a risk-off phase. There's a lot of potential for a lot of disappointment. People are nervous."

However, other managers see a turning point in Bund yields - the two-year is up from end-of-July lows - amidst pressure on Chancellor Angela Merkel to give ground on European debt sharing, and on debt-laden Spain to ask for a bailout.

"We're at inflection point. We would not be surprised about further near term repricing of German government risk," said ECM's Malik, a senior portfolio manager at the firm, which runs more than $9 billion in assets.

Malik is looking at Dutch and Austrian credit default swaps (CDS) - designed to pay out in the event of default - as a way of betting on a rise in German bond yields, as these may move more sharply than German CDS if its prospects deteriorate.

"Merkel's coalition is weakening and the only way I think she'll survive the next election is through a grand coalition with the SDP. The two parties would have to compromise on the euro bond issue.

"The tipping point is likely to be Spain. If it has to take a formal bailout then you'll be exposing Italy further plus increasing rescue costs which surely means higher (German) yields."

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