Author: Eric Uhlfelder

18 August 2010, Barrons

As Finisterre Capital demonstrates, some of the most intriguing debt plays are not in developed markets.

As an avid windsurfer—well before the days of the Internet and thoughts of managing a hedge fund–Yan Swiderski would listen from his home in England to BBC shipping forecasts to hear wind conditions off a fabled northwest shore of Spain. This particular stormy, distant coastal point abutting into the Atlantic was known as Finisterre.

When it came to branding the London-based emerging market investment firm he teamed up with, Swiderski, 48, thought there wasn’t a more appropriate name. “Literally meaning, ‘at land’s end,’ it captures much of the emerging markets story,” he recalls, “looking out from the old world across stormy waters to a new one.” His principals agreed, and the firm’s subsequent performance has shown its managers know the waters well.

Since it’s inception in April 2006 through July 2010, Finisterre’s $720 million flagship Global Opportunity Fund—which Swiderski manages with the help of firm’s six analysts– has generated annualized returns exceeding 13.6 percent. That’s nearly five full percentage points per annum more than the JP Morgan Chase Emerging Market Bond Index Global Diversified. It annually outperformed the MSCI Emerging Market Equity index by nearly 5.4 percentage points, suggesting that this still active windsurfer has not only figured how to produce superior bond returns, but how to top emerging market stock exchanges as well.

He invests in sovereign and corporate debt, foreign exchange, interest rates, the occasional equity, and special situations. “There’s a lingering misperception that all emerging markets are more risky than developed markets,” says Swiderski. He acknowledges that some are susceptible to politically induced policy changes, sudden liquidity contraction, and long-term shifts in commodity demand. And then there are the occasional sovereign blowups: Mexico, Southeast Asia, Russia, Argentina, and Brazil.

But the last event in São Paolo occurred nearly a decade ago. “What’s important to keep in mind is that these events don’t occur overnight,” says Swiderski. “There are many economic and political indicators that forecast difficulties.” And as the current financial crisis revealed, many developed market economies are actually in more trouble than their emerging market counterparts.

Swiderski says the macroeconomics of some emerging markets are compelling. Reserves and current account surpluses are expanding, public debt is declining, and inflation is under control as officials are embracing more responsible monetary policies. This includes letting currencies float, which reduces exposure to externally induced stresses. Moreover, emerging markets are seeing favorable demographic shifts, including growth in young workers and an expanding middle class that’s fueling domestic demand, making for more balanced, less volatile economies.

“Certainly emerging markets were hit by the financial crisis,” says Swiderski, “but most remain systemically sound.” And his macro-driven investment approach was quick to exploit this fact.

When the market bottomed in March 2009, he started buying bonds of the Russian state-owned VTB Bank. He amassed a $70 million position in the bank’s 6 7/8 percent dollar-denominated debt due in 2018 at a cost between 69 and 82. “We thought the market was seriously mispricing these securities,” says Swiderski, “because it didn’t understand the Russian government was funneling liquidity into companies through this institution.”

This fact was made even clearer during the crisis when the government increased its stake in VTB from 77 to 85 percent. Swiderski says the bank was never in serious trouble because of state support. An added plus: bonds were putable at par in 2013, when the bank would be obliged to pay the full value of the bonds to investors upon request.

The fund gained 33 percent on this investment, having sold out of the securities early this year at around 102.

Swiderski will occasionally make a pure FX play as he did this past February. He saw the Brazil real trading cheap versus British sterling. “We purchased 2-year options notionally worth $100 million, believing we are seeing a particularly attractive opportunity where two currencies are moving in opposite directions.”

The real is strengthening on commodity-driven economic growth, improving credit, a sound banking system, and improving government finances. Meanwhile, sterling is structurally challenged by a contracting economy, a broken banking system, current account and government deficits, and a worsening credit situation. This suggests a need for currency devaluation to help address these imbalances.

Swiderski was also concerned at the time that the pending UK election would produce a coalition government, which historically has never worked very well in Britain. While collaborative leadership has so far performed better than expected, his options are up 28 percent as of the beginning of August.

Swiderski pushed the limits of emerging market investing in spring of 2009 when he sold five-year Credit Default Swaps on US-dollar denominated Kazakhstan sovereign debt…that didn’t exist. “At the time,” Swiderski explains, “there was no deliverable obligation.” Such CDS underwriting is rare, he admits. But there was demand by investors with exposure to the country looking for some form of hedge.

Swiderski collected premia ranging from 500 to 1450 basis points on several $5 and $10 million CDS. But as the seller, he was ultimately on the hook for $75 million, which at the time represented 21 percent of the fund. Despite no underlying security, the price of the CDS were based on US-dollar-denominated Kazakh bank and utility bonds of various durations, and foreign exchange rates.

CDS prices did soar as emerging market credits got hit very hard by the financial crisis. But Swiderski thought investors were overestimating Kazakh government risk. “They feared damaging current account deficits, the collapse of foreign direct investment, and a severe banking crisis that would leave the government responsible for massive external debt,” explains Swiderski.

If conditions did worsen, he believed the government would not need to pay exorbitant spreads [which was implied by the CDS pricing] because it had access to affordable financing options from the IMF, Gulf States, China, and Russia. But the worst did not play out. Economic growth recovered. FDI was sustained. The government let several major banks fail. And Swiderski bought back his CDS as spreads fell, netting more than 25 percent from the investment. Today, the CDS are selling for only 200 bps.

Finisterre isn’t always on the right side of trades. Its only down year was 2008 when the fund was off 5.9 percent. But it could’ve been a lot worse. “It was one bad event after another,” recalls Swiderski. The fund was long oil credits and Gulf equities when oil prices collapsed in July. Then the following month, his long Russian and Georgian positions were hit when Russia invaded Georgia. Soon after, Lehman failed. And by October, over-the-counter markets malfunctioned [on which much of the emerging market trades are transacted] as the financial crises unfolded.

The fund’s most notable misstep occurred last December when the credit crisis caught up with Dubai. Toward the end of 2009, Swiderski had built up a $120 million position in the region. Despite concerns about how leveraged Dubai had become, Swiderski thought that oil prices would continue to recover from the mid-$40s, and that government’s implicit support of key local companies would be borne out.

However, when it was clear that there wasn’t enough money to cover a maturing $4 billion bond issue of a subsidiary of Dubai World due in December, the government blinked. Knowing there were billions of dollars more of debt coming due, the Ministry of Finance initially responded by announcing it would restructure Dubai World’s debt. The market read this to mean the government would not be standing directly behind the debt. “Officials showed incoherent decision making, lack of transparency, and policy confusion,” says Swiderski. So within two days of the initial announcement, the fund got out of its entire position and lost about 10 percent on these investments.

Cutting losses once an investment thesis is no longer certain is one way Finisterre controls risk. Shifting the fund’s net position is another. “We’re now slightly net short where early in 2009 were significantly net long,” remembers Swiderski.”

Specific risk management also involves analysis of gross leverage exposure, liquidity, value at risk, risk concentration and limits, as well as stress tests and default scenario analyses. “These measures help us identify and respond to various matters that could hurt performance,” says Swiderski.

Ultimately, the fund’s fortunes are based on the manager’s ability to correctly identify mispricing in less traveled, underreported markets. As the amount of sovereign and corporate emerging debt market expands, Swiderski believes it will outperform developed high-yield bond markets, an assertion he has already proven in profitably navigating the waters across various emerging markets.

Through July 2010
Finisterre Global
Opportunity Fund
EMBIGD BoA/ML US High-Yield Index
YTD through July: 7.01% 9.85% 8.37%
1-Year Return: 16.49% 19.44% 24.26%
3-Year Annualized Return: 12.63 10.09% 8.76%
Annualized Return
Since Inception [April 2006]:
13.62% 8.75% 7.99%

July 2010

Long: Short:

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