Heads We Win, Tails You Lose: Hedge Funds Love Greek Bonds

Includes: GREK
by: Colin Lokey

On May 4, an article appeared in the New York Times entitled "A Band Of Contrarians, Bullish On Greece." At the time, Greece had recently completed a debt restructuring which saw private creditors take a 75% haircut on the Greek bonds, helping Athens to reduce its debt load by 100 billion euros. Among those who suffered in the PSI was the president of New York hedge fund Greylock Capital Management, Hans Humes. Humes was also a member of the steering committee which negotiated the swap with the Greek government in March.

When one takes it on the chin to the tune of a 75% loss, there really are only two options: 1) take the loss and get as far away from the securities that caused that loss as possible or 2) assert that ultimately it was the market's fault for mispricing what are in fact valuable assets, and boldly double down on your bet going forward. Mr. Humes and Greylock, who, according to themselves, are experts at "identifying under-analyzed and inefficient markets, and extract[ing] value through strategies built on years of international restructuring experience and on-the-ground investment analysis," chose to blame the market and stick with Athens.

In fact, Humes went so far as to say to the Times in May that Greek debt was "the no-brainer... trade of the year." It would be difficult to imagine a worse call. In the three weeks following that article, the yield on Greek 10-year bonds rose nearly one thousand basis points.

That was then. Since that time, Greek bonds have rallied along with other European periphery debt, largely on the strength of investors' belief that the ECB will not allow a catastrophic event such as a Greek exit or a Spanish restructuring to take place. Now, the Greylocks of the world look quite smart even if, to quote the Wall Street Journal,

"...the bonds fell so hard in May that it took months for them to rise above their prices just after the March restructuring."

Third Point's Daniel Loeb for instance, was up several hundred million dollars after buying Greek debt for 17 cents on the dollar in July and August. As for Mr. Humes, according to a Wall Street Journal article cited above, Greek bonds now make up 20% of Greylock's entire portfolio. While I cannot say how Greylock itself has fared since Hume's horribly ill-timed "no-brainer" comment, it is probably safe to say the fund hasn't performed quite as well as some of its peers who waited until late in the summer to begin buying at between 12 and 17 cents on the dollar. According to the New York Times piece cited above, Greylock was actively buying the bonds for as much as 25 cents on the dollar back in April/May.

What is clear however is that the hedge funds who bet on Greek debt and are now taking their victory lap aren't yet content. Indeed the Wall Street Journal article mentioned above indicates that many of the hedge funds who own the debt still see substantial upside. Here's Humes again:

"You don't get a lot of opportunities like these."

Economist Gabriel Sterne from Exotix Fixed Income agrees. Exotix is "a leading specialist in illiquid bonds and loans" and relies on an "ideas-driven approach to provide high returns... in frontier markets and Southern Europe." In a note which the firm says will "contribute to an ongoing thorough re-assessment of our Greek views," Sterne argues that the IMF's projections for "key macro-variables" in Greece have become increasingly more realistic and this should serve, going forward, to prevent Greece from failing to live up to its promises by keeping expectations realistic. While this particular note isn't meant to support any investment thesis, it is part of a series which ultimately leads Exotix to "maintain a Buy recommendation on all GGBs."

It is worth looking at what the firm says about the IMF's stance on Greece in order to demonstrate how contingent and precarious this entire situation has become. Notably, Sterne argues that the IMF [emphasis added]

should treat the institutions of Europe more as part of the problem, and less as part of the solution. The 29 June Eurogroup agreement affirmed the need to "break the vicious circle between banks and sovereigns" and policies have been backtracking ever since. And Europe has been far too reticent in terms of offering more generous OSI, an issue which has bothered the Fund for some time.

Furthermore Sterne argues, like Bank of America Merrill Lynch, that the IMF simply will not continue to support Greece in the absence of a debt restructuring on the part of eurozone governments (OSI): [emphasis added]

We think the Fund should and probably will continue to support a Greek programme. It faces a presentational challenge in continuing its involvement, since it will be lending into an unsustainable debt burden, but we think a sensible fudge is achievable, in which lending can be justified on the basis of avoiding contagion and that future OSI may restore sustainability.

Indeed part of the "Buy Greek Bonds" thesis rests on the idea that given the relatively small percentage of Greece's debt now held by private creditors, there would be little point in imposing losses on the private sector again:

With so little debt in private hands, investors like Mr. Humes say, it would make little sense for Greece to force another restructuring on private investors because it would make no more than a small dent in Greece's daunting debt burden.

But relief is going to have to come from somewhere and German Finance Minister Wolfgang Schaueble has publicly stated that there will be no haircut on publicly held Greek debt and ECB President Mario Draghi has similarly denied the possibility of the ECB writing down its Greek bonds, equating such a move to monetary financing.

The most likely scenario, says Megan Greene, Director of European Economics at Roubini Global, is that there is an OSI -- accompanying a 'Grexit':

"Rather than Greek OSI being used to return Greece to debt sustainability and extend its time in the EZ, I think the trigger for OSI will come when the troika deems that Greece has failed in its adjustment program and cuts Greece off from further tranches of loans. In that case the ECB, EU creditors and EFSF won't have much of a say whether their Greek government bonds and loans are senior or not- they are all de jure pari passu... we are likely to see OSI in Greece, but only once everyone has given up hope on Greece's EZ membership, not as a way to extend Greece's lease on life in the currency area... When do I think this trigger for OSI will come? Possibly as early as the first half of next year if the current Greek coalition collapses and is replaced by a Syriza-led, hard bargaining coalition that goes to the brink with the troika and is too inexperienced to pull back.

This would most likely qualify as what the Wall Street Journal calls a "significant caveat" to the exuberance exhibited by hedge fund managers regarding the prospects for Greek bonds:

...the pain of a continued recession could bring to power leaders less concerned than Mr. Samaras about repaying debt.

That's ok, according to a hedge fund manager quoted by the Journal who cheerfully noted that historically, even in the event of a default,

...it's pretty hard to find anything below 10 cents.

That isn't likely to be very comforting to investors whose money was used to purchase GGBs at 20 cents.

The takeaway here is that Greek bonds are being disingenuously pitched as some kind of wonderful value -- the investment opportunity of a lifetime. This is about as far away from the truth as one could possibly get. GGBs are the very definition of a risky bet and it appears that the worst case scenario is indeed the most likely: Greece will be cut off from aid and every creditor will end up taking further writedowns.

That's not a big deal for the hedge funds betting on this junk though, because as ZeroHedge notes, the 2 and 20 hedge fund compensation formula basically amounts to the following deal for clients in the event of a catastrophic loss:

Heads we win, tails it's your money we just lost.

From their perspective then, GGBs really are a great opportunity. Investors however, should do themselves a favor and steer clear of local-law periphery debt at all costs.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.