Guest: Tina Vandersteel is the head of GMO’s Emerging Country Debt team. Prior to joining GMO in 2004, she worked at J.P. Morgan in fixed income research developing quantitative arbitrage strategies for emerging debt and high yield bonds.
Recorded: 1/31/2024 | Run-Time: 52:23 
Summary: In today’s episode, we dive into Tina’s teams’ recent piece about what they call a possible “once-in-a-generation opportunity” in emerging market local currency debt. Tina gives a great overview of the emerging market debt asset class and then we dive into the reasons behind her team’s call. She shares why today is reminiscent of 2004 and how she thinks about things like liquidity panics and sanctions risk. And you won’t want to miss her hot take on China.
It’s not often you see the words ‘once-in-a-generation’ from a well-respected shop like GMO so I’m excited for you all to listen in.
Comments or suggestions? Interested in sponsoring an episode? Email us [email protected]
Links from the Episode:
- (1:27) – Welcome Tina to the show
- (2:08) – Overview of emerging market local debt
- (4:27) – What are Brady Bonds?
- (7:53) – Delving into sovereign debt issues
- (11:29) – No Stone Unturned
- (12:58) – The overvalued US dollar
- (25:00) – China’s place in emerging debt markets
- (29:33) – Identifying countries at risk of default
- (37:35) – Highlighting opportunities arising from geopolitical events
- (42:12) – Tina’s most memorable investment
- (47:00) – Sharing Tina’s most controversial viewpoint
- Learn more about Tina: GMO
Transcript:
Meb:
Welcome, welcome everybody. We got an awesome episode today with another one of the GMO crew. Our guest is Tina Vandersteel, who’s the head of GMO’s emerging country debt team, and she’s been there for almost two decades. In today’s episode, we dive into Tina’s team recent piece about what they call a possible once in a generation opportunity, I love to hear those words, in emerging market local currency debt. Tina gives a great overview of the emerging market debt asset class, and then we dive into reason behind her team’s call. She shares why today is reminiscent of 2004, how she thinks about things like liquidity panic, sanctions risk, and you won’t want to miss her hot take on China. It’s not often you see the words once in a generation from a well-respected shop like GMO, so I’m excited for y’all to listen in. Please enjoy this episode with Tina Vandersteel.
Meb:
Tina, welcome to show.
Tina:
Thanks, Meb.
Meb:
We’re going to have a lot of fun talk about all sorts of different topics all around the world today. One of the things, I’m going to lead in with a quote that you guys had in a recent piece on emerging market local debt, which said, “Arguably, this is the best set of conditions we have seen in 20 years.” 20 years is a whole career. So we’ll get into that exact quote in a minute, but let’s start out with, what does that even mean, emerging market local debt? I feel like most investors may have heard of that, some far flung crazy asset class, but give us a little overview.
Tina:
Sure. So emerging markets debt in general just means we gringos lend to countries, and local debt means we lend to them in their own currency, as opposed to lending to them in dollars or euros, or wherever the developed markets are. And so that comes with a unique set of characteristics different from lending to them in dollars. Obviously, the currency is the big differentiating factor, so you kind of want to do that when the currencies are cheap and can stand a chance to appreciate relative to your home currency.
Meb:
I imagine the average American, even a lot of the pros, this asset class probably rounds to zero in their portfolio. But talk to us about the size of the universe because foreign bonds in general is a giant asset class. Talk about the different types of debt. What does sovereign debt even mean?
Tina:
There are benchmarks, obviously, for the asset class.
Meb:
What’s the most famous, by the way? Is there like a S&P of the emerging markets?
Tina:
There is. The oldest one, actually, I was on the team that created it. It’s called MB Global Diversified these days, but back in the day it was just called MB. And we put this out. At the time I worked at JP Morgan, and MSCIEM, the Emerging Equities Index had only come out a couple years before, and so we were all in the emerging markets basically trading defaulted bank loans and trying to turn these into tradable securities. And as part of that, my boss at the time said, “Hey, we can’t get institutional investors interested in this as a thing unless there’s a benchmark for it.” And so we got out all of these very, very complicated loan documents back at the time for these very, very complicated securities, which were then called Brady Bonds, and modeled them up and created an index out of them.
It was not a particularly diversified index in the beginning. It was only a handful of countries, but it has morphed over time to add more countries and more types of securities. And now, it has, I don’t know, more than 70 countries in it, something like that. So that’s the oldest one.
Meb:
I imagine listeners, they hear Brady Bonds, they’re probably thinking Tom Brady, but that’s not what a Brady Bond, is it? Is something else.
Tina:
Yeah, so Brady Bonds were named for a Nicholas Brady. And if you rewind the clock even earlier, so in the 70s and 80s, back then the only people who lent to emerging markets were the banks, the money center banks, the Morgan guarantee trust, the banker’s trusts, and all of that. And in the 80s, after Volcker jacked up interest rates, the countries couldn’t repay the debt. They were all LIBOR floaters, and interest rates went up so quickly, they couldn’t repay. And I think Mexico defaulted first in ’82, and then pretty much the rest of them defaulted. A couple of exceptions didn’t end up defaulting. And then the first plan was called the Baker plan, actually, and that was sort of an extend and pretend, if you will, and hope that things got better, but they didn’t manage to get out of default. And so Nicholas Brady came along with this idea that said, “Okay. Well, what if we made the bonds more attractive by offering features that made them safer?” So he introduced, for example, the idea of principle and interest collateralization. What that meant was I’m buying a Mexican bond.
But if Mexico doesn’t pay, I’m guaranteed to get my principle at maturity. And some of these were 30 year bonds, so you would have to wait. And in some cases, you got what was called a rolling interest guarantee. So the next N coupons were also guaranteed to be paid. There was a collateral account set aside for that payment. And what that meant, Meb, was that these were intensely complicated securities. Because the original recipients were the banks themselves, depending on how the banks had treated the loans, had they written them down or not written them down, and the US banks were different than the Japanese banks and the European banks in how they had treated these loans, they were either interested in getting back something called a par bond.
And a par bond meant if I gave you a hundred dollars of loans, I got back a hundred dollars of bonds, or I could get a discount bond. I give you a hundred dollars of loans, and I get back 65 of bonds. And to make them NPV equivalent, you would have to have a very low coupon on the bond relative to a market coupon on the discount bond. Those were actually relatively simple ones. Then there were other ones that came with capitalization factors and amortization factors. Some of them capitalized interest at floating rates, so you didn’t know what the ultimate principle of the thing was going to be. So they were very, very complicated bonds to model, and for some of us, that made them really fun things to look at.
Meb:
Yeah, well, all the bond crisis of your, they always had fun nicknames like tequila crisis. And the history is littered with bond crisis, which sort of leads me to the next concept where imagine if people are listening, they say, “Okay, I think I have an idea of what sovereign debt is.” I realize there’s also probably different types of debt of different credit ratings and duration. But I imagine in most people’s mind, when they hear this, they think something yielding 20% like an Argentine bond that’s going to default every decade or something. But maybe give us an overview of what that world looks like today as far as credit quality and yield and duration.
Tina:
There’s not a one size fits all answer to this. Within the sovereign debt space, what makes sovereign debt unique from, say corporate debt, is that with very few exceptions, the sovereigns never go away, right? You mentioned Argentina. They may default every few years, but eventually, they have to renegotiate and continue to pay. We have actually had some default restructure and not reissue and just leave the asset class believes did that a few years ago, but those are kind of the exceptions to the rule. So sovereign debt is, at least foreign currency sovereign debt or dollar sovereign debt, is something that is always benchmark eligible even when it’s in default. So we have countries in the benchmark that are AA rated and ones that are in default, and everything in between, which makes it a little bit of a weird asset class, right? Most people in credit are either investment grade people or they’re junk people, or they’re distressed people. But for us, we get some of everything and sovereign debt anyway.
In local currency debt, usually it’s the better countries that are able to borrow in their local currency that foreigners would lend to them in their local currency. Those are at least index eligible ones. Then there’s another subset of what we refer to as frontier local markets where it’s very difficult to access. It may be very difficult to get your money back. And generally what defines frontier is either lower credit quality or very difficult to access markets, something like a Paraguay or a Dominican Republic, for example. And then there’s corporate debt. And within corporate debt, there are really two types of corporate debt. The predominant type are quasi sovereigns. So by quasi sovereigns, they’re sort of like agency debt, right? You may recall that in 2008, our friends Fannie and Freddie were put into conservatorship and not allowed to default, notwithstanding the fact that their bonds are not actually guaranteed by the federal government, but you and I and other taxpayers wrote some checks to make sure that they were going to continue to pay, right?
Those are the kinds of things that we refer to as quasi sovereigns in emerging markets. And there’s everything from very close, a Fannie Mae, to more questionable whether or not the sovereign’s going to keep them going. And then there’s what we refer to as pure corporate debt. So this is a beverage company in Mexico or something like that where there’s no hope of sovereign support. And so those kinds of debt markets have compound risk because they have implied Mexico risk if they’re in Mexico, because after all, their assets are in Mexico and the regulatory environment is Mexican. And so they have a lot of embedded Mexico risk, but they could also default on their own because of things that happen, or there’s fraud or whatever there is. So each of those buckets, the hard currency sovereigns is about a trillion. Local currency sovereigns is around 2 trillion, but half of that is China. So in local currency debt, the benchmark constrains larger countries, because otherwise, you would just have a very lopsided benchmark. And then corporate debt’s also about another trillion.
Meb:
So it’s big-
Tina:
It’s big.
Meb:
… is the takeaway in my mind. And it’s fun. I had a good time. We’ll link to some of these pieces in the show notes, listeners. There was one called, a few years old, but called No Stone Unturned. But it’s fun to look. There’s a very long laundry list of countries. So it’s not just China, Mexico, but you go all the way down to Oman, Uruguay, Ghana, on and on, Serbia, Ivory Coast, Georgia, Gabon.
Tina:
Yeah, it’s fun for me because at dinner… I have a couple of kids, and at dinner everybody goes through their day, but my day is, “Guess what country mommy had a transaction in today?”
Meb:
Yeah, you got to find it on the map.
Tina:
Got to find it on the map.
Meb:
It reminds me a little bit of the old Jim Rogers investment biker adventure capitalist books where he is traveling all over the world, and some of these are pretty far flung. I feel like the bond investors still is much more frontier than the equity investor, it’s hard to get much interest, particularly in the US, this cycle, to even move outside the borders at all. But God forbid, as you go down from foreign to emerging to frontier, forget about it. All right, so we got a pretty good overview so far. Why is this something that we should start to consider for both investors and pros alike. But also, I think you got to talk about the dollar, right? That seems to me like people, they start to get interested in this asset class, but then their brain kind of is like, “Well, what do I do about the dollar? Do I hedge this? Do I not hedge this?” How do you guys think about that?
Tina:
Everything that we do at GMO and especially in the fixed income department has to do with value, right? We’re value managers. And so we publish a publication called The Quarterly Valuation Update that tries to answer for our clients the question, is the thing well valued? Is sovereign hard currency debt, as represented by the benchmark and be global diversified, well valued today? And we break that problem into its two main component pieces. One is the lending piece that you’ve lent to AA through defaulted countries, and the other piece is dollar duration, right? It’s six seven year duration asset class, so is dollar duration well valued? And the emerging piece anyway, I think lots of people can come up with ways to think about dollar duration, so we’re always focused on the emerging piece. We put together something which we refer to as the expected credit loss, right? So the asset class has the spread of around 400. So if you can scale that high yield, CDX high yield is maybe 350, 360, something like that.
So this has a wider spread than US corporate high yield currently. And at around 400, what kind of loss experience can you expect? And the way we come up with that is kind of clever, I think. It asks the question, well, what has been the historical experience of sovereign credit transition? What do I mean by that? It means that for… We have AA, single A, all the way down all the letter ratings. So if you look the rating agencies tabulate each year, all of the countries that started a particular letter rating, where did they end up at the end of the year? Some of them stay the same, some of them get upgraded, some of them get downgraded, but what’s been that credit migration? Right? And then you can average this experience over the whole history of sovereign debt.
And we look at that, and what’s interesting about sovereigns, different from corporates, different from US corporate high yield, is that in sovereigns, you can generally assume default independence. So in other words, Argentina defaults every few years, but it doesn’t cause Brazil or Mexico to default. Whereas in corporate high yield, maybe some high yield energy company goes bust and sells assets at a level, and that causes another bust, and so forth. So there’s default concentration or industry concentration. Here, because you can assume default independence, you don’t have to think about a default cycle, like you would in credit and high yield credit. And so given that, we take that historical credit transition, and we ask ourselves, okay, for each country in the benchmark, what is the average life of that country? Because obviously this is just a one year transition, and default intensity or default probability grows with time, right?
So through matrix math, you can come up with a buy the average life of each country in the benchmark, default density. And we assume that if you trip into the default, you recover 25 cents on the dollar, which is a fairly conservative assumption. With all of those ingredients, then we can keep track of the benchmarks constituents through time. Remember I said it started out with a handful of countries and now has 70 something countries. So at every single day, we know what the constituents are and their weights are, and we generated a fault density for each country. And then we estimate. We tabulate this all up and come up with an expected loss. So right now, it’s a little over a hundred basis points. So you take the credit spread and you divide it by the credit loss, and that’s what we refer to as our credit spread multiple.
Meb:
That’s really interesting. I hadn’t thought about that in a while, about sovereigns, about it being less correlated as a group versus something like US corporate bonds that tend to move together.
Tina:
And this only… So far, we’ve only talked about hard currency. We have whole valuation metrics for local currency. So in local currency, now you have two things you have to value. You have to value the currencies and you have to value the bonds that they’re associated with. So in currencies, we decided to try and come up with an analogous thing to what I just talked about in credit. In credit, you have this big spread you’re going after, but you’re going to suffer some losses, right? In currencies, generally developed markets have lower yields than emerging markets, right? So you go to the emerging markets for, so-called carry trade, right? You’re going for the high yield. But it turns out that that’s not always the case in currencies. Some of the emerging markets currencies have lower yields than the us, so it’s not inevitable that you have a higher yield. But regardless of your starting position, let’s say today as is the case, currently the yield is a little higher on average for the benchmark than US yields.
Meb:
What’s the ballpark?
Tina:
It’s not that much right now, only because US yields are quite high, right? These are cash yields, so US cash yields are five and change. And so probably the cash yield on this thing is six, call it.
Meb:
But also in general, the emerging category didn’t get into a lot of the foreign developed zero negative category for the most part. Is that correct?
Tina:
A bunch of them did. A lot of … the Czech, Poland, Hungary.
Meb:
Okay, so the European names.
Tina:
Europeans did. Some of the Asians did. But, I mean I remember a 3% … rate in Brazil. That’s just crazy to me, that rates could be 3% in Brazil for a while. You have this starting carry, which is generally positive, but it doesn’t necessarily need to be positive, right? And then you have the fundamentals of the currencies themselves, right? And we all know fundamental analysis on currencies is actually pretty hard to do, so the band of uncertainty around this estimate is a bit higher than it was back in credit.
Meb:
We can’t just use the Big Mac.
Tina:
We can’t just use the Big Mac, no. We have quite some sophisticated valuation techniques that go into this. But what those resolve to is this basket of currencies priced to appreciate in spot terms or depreciate in spot terms. So if you think back to 10 years ago, because US rates were zero, for so long, the carry was this big positive number, but the fundamentals were so poor that it overwhelmed the carry, right? The spot would depreciate by more than the carry you went to collect. And in our valuation metrics were like, listen, the dollar is cheap, this stuff is rich. We wouldn’t look at it now. And you fast forward to today, and now you have a small positive carry, but it’s really the fundamentals of the currencies, the richness of the dollar and the cheapness of these currencies that you should expect spot appreciation to bump up your carry.
So that’s the currency piece. And then the rates piece is similarly well valued. We look at it as a fundamental gap versus the United States, and that gap is very high. So as a package. The currencies plus the rates make local. This is what we like so much about local debt.
Meb:
I’m heading to Japan tomorrow. Is the US dollar broadly overvalued versus most payers, or do you really got to treat it on an individual basis?
Tina:
It is broadly overvalued against almost all of the payers. Victoria, who wrote the piece that you referred to, she’s the person who comes up with the fancy analytics. And I manage hard currency these days, but my more simple method of figuring this out is observing people who come to visit us. So two types of visitors. We get visitors from the countries we invest in, the state of Israel was in our offices yesterday, and clients who also themselves come from all over the world. And I like to see whether or not they’ve been shopping. 10 years ago to a person in every single meeting, somebody would have a shopping bag from somewhere, right? Nobody left empty handed. And my Swiss clients would come over, they’re like, “We’re going to hit the outlets while we’re here,” and all of this stuff.
These days, people come to visit us, nobody goes home having shopped, not even the Swiss. So it looks to me that the dollar is very overvalued.
Meb:
So listeners, you hear that go on your vacation now, Americans, you prepay for it. That’s an even better idea. Years ago, I had a trip, I don’t even remember, where I was going, where in between paying for it and the actual trip, the currency had a pretty big move, and they said, “Hey, actually, we’re going to have to add a surcharge because the currency had a pretty big move.” And I said, “Well, just to be clear, had it gone the other way, I’m pretty sure you wouldn’t be refunding me money. This is a one way payment that’s happens. But okay, I hear you.” I think the challenge for a lot of investors is it feels to me like currency valuations play out on a similar time horizon as general equity market valuations or something like… People want it look at it on a monthly or quarterly basis, but is it true the currencies, you’re like, well, this could take years to resolve? Or how do you guys think about it?
Tina:
So once the trend in the broad dollar is established, it takes about these 10 year swings. This is why we said it hasn’t looked this good for 20 years, because it took a swing up or a swing down in the beginning, and then a swing back up. And so to us, we’re starting from a place that is very reminiscent of 2004. And at that point, the dollar went on to take a huge swing down between 2004 and 2011, and it was a fantastic time for emerging markets currencies. And then of course, the dollar bottomed out and we’ve seen the last more than 10 years, right?
So I think it’s even hard sometimes to get some of the younger people around me in fixed income excited about this idea because as long as they have been working, the dollar has only gone up, it’s probably the same frustration that equities people feel when they leave the US market and they try and find foreign equity markets or something like that. And then in recent years, the only thing that you’ve known is the US market has outperformed. So you stick your value hat on and you think the other way of course,
Meb:
Is this pretty rare, for it to have this combination of this setup as far as cheap currencies and high rates?
Tina:
It is very rare. Again, a combination we’ve only seen once before, and it was 20 years ago.
Meb:
I love the once in a generation comments. We’d been talking about, with a lot of your compatriots, about value investing over the last few years. And anytime people say something where it’s like this is not just top 10% of history, but top 5% … or this has never happened before, once in a generation, my ears perk up. Because we know it can always get worse, but to me, that gets to be pretty interesting. All right, let’s talk about a few jump off topics that I think are all relevant to this, the first being China is obviously a huge footprint on the equity markets, and they’ve been in a world of hurt for the past handful of years. Do they have a similar shadow in the debt world or are they a smaller portion? And how do you guys think about China in general?
Tina:
So it’s been my longstanding opinion that China doesn’t really belong in the emerging debt markets. It’s sort of like Japan with respect to the rest of the developed markets, debt markets. It’s its own thing.
Meb:
That feels like not very consensus. I love this. Tell us why.
Tina:
Well, just start by understanding that China local markets have not really been investible by foreigners until fairly recently, right? And so it was basically a giant closed market. And so US rates go up and down and Brazilian rates go up and down, and Chinese rates have nothing to do with the rest of them. And from an investment standpoint, we like to play relative values, so we need things to sort of move together. The first principle component should be global interest rates. And China had really no sensitivity to that because, again, it was closed to the rest of the world. It’s starting to have some sensitivity to it. But China rates are low, and they’re not particularly attractive. China uses financial repression extensively to solve its debt problems. So it’s not a great destination place. In dollar debt, China has very, very few dollar borrowings. It’s a giant current account surplus, tremendous reserves.
They don’t need to borrow in dollars at all, but they throw a few dollar bonds into the market to establish a dollar yield curve for their quasi sovereigns and corporates. But those things pay treasuries plus 25 or something like that. The whole asset class is paying 40. Something at 25 is not really an interesting thing. And if you can buy USIG at 55, you don’t really need China at 25, right? It’s relative to nothing, doesn’t look attractive. China is also a big lender to the emerging markets, belt and road and all of that.
Meb:
That’s kind of a unique position. Are many other emerging countries lending their emerging countries, or not really? Are they?
Tina:
After China, it’s really Saudi and GCC, and they lend to the weaker GCC, the Omans and the Bahrains. But China’s a big lender. It’s a problem these days in debt workouts. Zambia has been dragging on for three years. There’s a whole China angle that gets to be quite complicated. And so I think to myself, it’s not attractive as an investment. They’re creditors to the rest of the emerging markets. Oh, and by the way, if you just take spreads on the rest of the emerging markets and ask what relationship do those spreads have to Chinese economic fundamentals, some sort of a high frequency GDP or PMI, something like that, you find that there’s a correlation there because China’s growth contributes to world growth, and world growth contributes to debt repayment capacity of the weaker countries, right? So you’re indirectly lending to China when you lend to Ghana. But Ghana pays a lot and China pays nothing, so what’s the point?
Meb:
And I assume China, as far as the indices, is probably a decent chunk because for some of the emerging market indices on the equity side, well, it used to be. I’d say a third to half. It’s less now, but are they pretty equally as big?
Tina:
So in local currency, as I said earlier, they would be more than half. But in local currency debt, all countries are capped at 10%, so they’re maxed out at 10%. In hard currency debt, these days, everybody follows also the diversified version of the benchmark. There are many, many more countries, so they cap out at around 5%.
Meb:
Got it. You mentioned Argentina, which they got a new president there that the socials are, everyone seems a little more positive on. But I feel like every 10 years, we’re positive on Argentina and they just can’t get their act together, which is so sad, but hopeful that they can kind of figure it out. How do you think about Argentina? And then more broadly speaking, how do you think about countries that are either, I don’t want to say culturally, but just prone to defaults, or maybe it’s systematic, maybe it’s just whatever reason they are serial defaulters? Are they uninvestable in general, or are there certain things you look at to say, “Okay, well, maybe they’re allowed back into the fold”? How do you think about that?
Tina:
Well, first of all, I’ll go ahead and admit that I personally don’t think about that a lot. The division of labor within my group is that I have a couple of sovereign analysts, and it’s their job to analyze countries. As the portfolio manager, it’s my job to select individual bonds for the portfolio and to try to balance default risk against upside potential. But what I would say is that one of our sovereign analysts, Carl Ross, who’s been around in the business for more than 30 years now, he wrote a piece, gosh, I want to say 10 years, it was probably after the last Argentine default, that talked about serial defaulters. So Argentina, Ecuador, Belize, back in the day, Congo, and a few others, because if you were to look at any measure of credit risk, and of course, the sovereign team here has their own measure of credit risk, but you could use ratings or whatever it is and ask, “Do sovereign spreads line up with apparent sovereign credit risk?” The answer is mostly yes, right? The market is relatively efficient on this score, but the serial falters look cheap, right?
If the ingredients to your credit risk estimation are the state of the fiscus, how much debt do they have, what’s their liquidity, the standard things, then an Ecuador and Argentina ridiculously cheap, especially since they just defaulted back in 2020. So prospectively, they should be better credits because they already wrote some debt down last go round, or at least lowered their coupons last go around. And so his paper postulated that there is a serial defaulter premium that you pay, and it’s unclear whether or not they’ll ever be able to escape it, right?
Some countries seem to have escaped it. Ivory Coast was a serial defaulter, and they just issued a bond last week. So it is possible to escape it, but it has not yet been possible for Argentina and Ecuador to escape it. Now, I’m as enthusiastic about Argentina as we were the last go around in the Macri administration, part of which is because the economic team is so good. The new finance minister is the same finance minister as Macri had, who was the guy I went to the training program with at JP Morgan. He’s a really bright guy.
Meb:
What are the things that you’re looking at when you’re examining some of these issues and putting them into the portfolio or things people may not be thinking about?
Tina:
In my section of the process, all I think about is one bond versus another bond relative value and trying to, as I said earlier, capture as much total return potential while limiting downside if the country defaults. Now, what does that mean in practice? So I said our universe starts at AA and ends in default. So if you’re in the nosebleed AA, very high credit quality stuff, generally the kinds of things, the individual sovereign bonds will be relatively well-behaved, not treasury like well behaved, but you’re not going to see one bond 50 basis points cheap to another, not generally, right? So there, you’re going to look a lot more at agency debt. Can you convince yourself that this is really an agency, it’s really a quality sovereign, it’s not going to idiosyncratically go off and default on its own? And within there, there’s some really interesting things that go on.
We have two analysts who look just at our quasi sovereigns, about 300 names. And again, it’s ascertaining that this is really a quasi-sovereign that’s not going to go off and default on its own, even if it may go on a very wild ride relative to the sovereign. So a recent example, a really fun one actually, that one of the guys on my team uncovered was an Indonesian quasi sovereign. So this was probably during the pandemic or maybe the war, I can’t recall because everything blows up when the market blows up, right? And because these things have additional information cost, right? There’s only so many of us who know about this group of bonds. And to get the marginal buyer interested, you have to educate them. In a crazy market that may take too long, right? Somebody needs to sell the bond today, and there are only so many of us who’ve already pre researched this bond.
So in this case, it was a corporate bond, and by that, I mean it was in the corporate benchmark, but it was a bond from Indonesia that had a parent quasi sovereign, more Fannie Mae-like quasi sovereign in the benchmark in the hard currency benchmark, the sovereign benchmark. But this little bond from a rubbish issuer, the financials of this issuer just terrible, they crossed defaulted to this other parent one that had a huge debt stack. And so he reasoned and we all agreed that there would be no chance that Indonesia would let the child qua sovereign default because it would trigger a default on their debt stack. And you had to read the offering documents in great detail to uncover this fact. But already knowing this fact, when people were selling that bond, it’s about to mature by the way, in the seventies and high 60s, we thought, all right, this is a great bond. So that’s something that can go on in the Indonesia is like a mid-investment grade country.
Once you get to the 500 and above spread countries, the ones with more meaningful default risk, then often what I’m looking at are basis packages. So in a basis package, you buy a bond and you insure it for default. And that way, if they default tomorrow, well, you know what you’re going to get paid. You’re going to get paid par because the default contract will pay you the difference between par and whatever the thing recovers, and the bond itself is deliverable into the CDS auction. So that way of thinking actually helped quite a lot as we went through the big set of defaults that we had in the pandemic. We bought basis in Argentina, Ghana, Ecuador, and some others. And so while the country goes on to default, you’ve hedged that case, and so you make relative return from having done that.
Meb:
I think of this in my mind as a not particularly efficient asset class. I end up being on text threads or WhatsApp groups with buddies, and often I tell them they’re focused on one security being Tesla, and they spend all this time debating if Tesla is going to go to 10 trillion or zero, or whatever it may be. I’m like, “You guys know there’s tens of thousands securities in the world. Why don’t you focus on one where not everyone’s attention is focused on, something less efficient?” It could be a small cap in the US. It could be stocks in your local neighborhood that doesn’t happen to be Boston, San Fran, or New York. It could be countries, on and on. And I think of this area in general, an area where almost no one is investing outside of the big institutions.
How much of the opportunity is driven by these big geopolitical moves, meaning wars, pandemics, things that happen and things go totally nuts, upside down, bananas? Is that a lot of the opportunity set, or is it fairly consistent just based on big structural moves between countries? Give us a little… Where do you find the gyms?
Tina:
It really depends on the market environment, the way we manage money. And this is unique in the industry, is we emphasize this idea of which securities did you pick rather than emphasizing which countries did you over and underweight? Now, there could be a lot of alpha in both, by the way. Last year, the dispersion of returns among countries was gigantic, right? Some countries tripled, and other countries returned basically the bare minimum. So there can be a lot of alpha that goes on in country positioning, but the way we think about that is that is a lot more uncertain, relatively speaking.
An analogy I love to give is imagine there were two versions of Apple stock… And this is going to sound ridiculous, but I don’t even know what’s the price of Apple stock?
Meb:
$184 a share.
Tina:
Okay.
Meb:
Down three bucks.
Tina:
Down three bucks. Okay. So one person will say, “Okay, $184, I’m going to compare that to the other magnificent,” however many there are these days, six, seven something or rather, “and I’m going to hope that I pick the winner and the loser.” But there’s a lot of idiosyncratic stuff that can go on, right? It sounds like that was seven, and now it’s six, so something idiosyncratic obviously happened. Now, what I like to do is I like to think, okay, pretend that this existed in stocks, which it doesn’t, but it does exist in my world. There is another Apple stock, call it Apple share B, and it trades at $174, but it almost never trades, right? And there are only a few of us who hold it. So we really trade it amongst each other.
And no matter what happens to Apple, I’m going to get the same economics, I’ll get the same dividend, I’ll get everything else. But someday those will converge, right? In Apple’s case, because there’s no maturity, they can’t converge at maturity. But if Apple were to liquidate, they would both mature at zero. So I have a 10 point cushion for the bad scenario, and if this were a bond, they would converge at maturity, right? And so it’s our job to uncover those share Bs and hold them as a source of return. And what’s nice about it is it’s a real sleep at night strategy because you know that they will converge when they mature, and you know they will converge if the country defaults. And again, if it’s a double AA country, you’re really thinking about convergence at maturity. If it’s a triple C country, you’re thinking that the default could be the place that it converges more quickly.
And I remember very, very vividly in 2008, everything blows up in 2008 with Lehman Brothers and all of that. And I should say that when there’s a liquidity panic, like a Lehman Brothers, let’s say Apple share A goes from 184 to 100, Apple share B goes from 174 to 20. So a huge liquidity discount builds up between the two of them in the liquidity panic. So during a liquidity panic, this kind of a strategy is now underperforming because the liquidity spread has widened on our little B shares. I remember actively hoping Ukraine would default because we would get back our alpha immediately, rather than waiting for the market to recover, because it took like eight months for liquidity spreads to recover after Lehman Brothers. So that’s the way we think about it. Now, there are other managers out there who play the top down country over and under weights, and they do a good job at it. It’s just not the way we go about it. And the median manager beats the benchmark by a lot in this asset class, so there’s room for both ways.
Meb:
I imagine you have lots of crazy stories. We usually save this for the end of the conversation, but feel free to chime in now about saying what’s been the most memorable investment. This seems to be like the most wild west of any guests we’ve had, and I’m sure you could tell all sorts of stories about craziness in this world, but any in particular come to mind? Feel free to tell more than one.
Tina:
Many of them have to do with Russia. Argentina is the default gift that keeps on giving, but Russia throws up some really wild stuff. In 1998, it threw up wild stuff. Fortunately, credit default swaps had just been introduced in 1997. This actually was an interesting case where in the lead up to the war, as a country idea in credit, Russia looked super cheap. If you just looked at its credit fundamentals, the sovereign team estimated Russia should pay around 100, and it was paying 300, but we all knew there were some risk that something weird could happen. And so I elected, okay, we’re willing to be overweight Russia a little bit, but I want to hedge it for default, which the cost of hedging it for default was virtually nothing, right? Because nobody thought anything terrible was going to happen. I’ve never seen a basis package pay out so quickly because they ended up defaulting a few months later.
At the same time, if I rewind to fall of 2021, one of the cheapest currencies we had in our universe was the ruble, at the time trading, I think 72 in change. And so we elected to buy some one year dollar puts, had high yields, we didn’t think it would deliver. The forwards ball was low, and that ended up being an unbelievably crazy situation because the ruble first blew up. I think it topped out at 130, something like that, something crazy. And so the delta of this option was worthless, but vol was so high that actually the option was appreciating in value. Now, of course, the currency became much more non-deliverable than it had been going into the war because now it’s basically cut off from world capital markets. So the fixing for the currency became in doubt, and they were going to change what the fixing was. And our option depended on this.
Meanwhile, we want to delta hedge the option. We have an option expiring in November of 2022, but the forward market collapsed to only being two weeks at a time. So that was an unbelievably crazy thing. We ended up making money on it, but boy, it was pretty unpleasant along the way. So yeah, a lot of Russia hassles.
Meb:
But yeah, I was going to say then fast forward 25 years later, here we are again. Did that have some broad reverberations throughout the EM debt world beyond just Russia, Ukraine?
Tina:
Well, this idea that the US Treasury could use this kind of sanctions, obviously, it’s built up the weaponry to have this kind of draconian sanctions, which right now is just Russia and Belarus got us thinking about sanctions risk in general. Russia as a credit was not noncredit worthy. They didn’t default because they couldn’t pay. They defaulted because we couldn’t receive the money, and that’s not credit risk. So I asked our sovereign analysts, “Could you come up with some guideposts for other countries that could become sanctioned? What things, obviously short of invading another country, might elicit such draconian sanctions? And so now we have a whole framework for that that we consider as part of investing.
Meb:
Yeah, the future is always weirder and stranger, even in the past. In the past, we have so many examples of craziness and sovereigns and everything else going on in emerging markets. So if you sit down with a panel of your buds in this world that have been doing emerging market investing for a while, whether GMO or elsewhere, and y’all are having a coffee or a beverage and you’re just shooting the and you say, “Hey, here’s a belief I have,” what is the belief that you might have that the vast majority of your peers would disagree with or shake their head? Where if Tina just sat down and made the statement about investing, maybe you’re like, “You know what? I don’t think who president matters in whatever it may be. What’s something you might say that people would disagree with, or there’s something that’s just not that consensus?
Tina:
I personally don’t focus on the kinds of things that rise to cocktail party chatter. Nobody wants to hear about esoteric features in individual bonds, which is my part of the process. I did float something that I thought was something that I’m interested in, but I don’t have any experience with to try and get the reaction from people who are economists and are country analysts and all of this stuff. And that is a series of papers that I’ve been curious about. One was back in 2008. You may remember in 2008 during Lehman, in the Lehman aftermath and all of that, the Fed was put in this crazy position where they were still raising rates because inflation was a problem, oil prices were high and all of that, but now they wanted to cut rates like mad because of Lehman Brothers. And I’ve seen that movie a bunch of times in emerging markets because you have conflicting things, and maybe you close your capital account or whatever it is.
And so at the time, the New York Fed wrote a paper called Divorcing Money From Monetary Policy, and they introduced this reserve corridor and paying interest on reserves and all of this stuff. Notice it didn’t probably, you don’t even remember that paper, but I remember that paper. No, definitely not. Yeah, I remember thinking from an emerging markets perspective, I’m like, oh, okay, they’re doing something very emerging markets here. I used to make fun of China. Oh my God, these guys don’t just target the overnight rate, they target rates all the way out to the 10 year rate. That doesn’t happen here in the US. Whoops. Well, actually, now it does, right? Yield curve control, yield curve targeting, quantitative easing, all of those things. And now, with an emerging markets hat on, I look at the debt to GDP in the US and the level of interest rates and the growing interest bill, I wonder, well, how are they going to get out of this? Right?
Financial repression obviously is the easiest way to get out of it, but do they have the tools really at this point? It’s one thing when debt to GDP was 70, 80. There was more fiscal space. But in an emerging markets context, they’ve run out of fiscal space. So now what’s going to happen? And the St. Louis Fed came out with this super crazy paper that basically said, “All right, what we’re going to need to do, since Congress obviously is never going to do anything… We’re never going to raise taxes, we’re never going to cut spending. Congress would just write them off, so the Fed needs to do something as the Fed always needs to do something. And the first thing we need to do is to broaden the inflation tax base. And how are we going to do that? Well, we’re going to introduce a reserve requirement, and then we’re going to stop paying interest on reserves. And then if we only run inflation at 6%, then we’ll get out of our debt pile in some reasonable timeframe. And I remember reading this just falling out of my chair.
This is like Argentina. This is what they do in Turkey, and you haven’t heard anything about that paper. So if I were at a cocktail party with a whole bunch of economists who know about these things, I usually ask them and they shake their heads. They’re like, “Well, that’ll never happen.”
Meb:
That’s the challenge. If you walk through the available options of how do you burn off the debt, there’s only a couple of choices. And running the engine hot, seems to me no one wants to talk about it as being a choice, but it kind of, in many ways, can be some of the least worst. As long as that 6% doesn’t become 10, 15, 20, 30, of course, which is the risk?
Tina:
Well, it’s the grill question is least worst for whom?
Meb:
Yeah, good point.
Tina:
When I think about some of my friends and the kinds of jobs that they have that have no pricing power at all, this is not least worse for them. It would be much better for them if taxes on rich people were raised. So it’s a political question. It’ll be interesting to see how it’s answered.
Meb:
That nobody wants to figure out. We’ll just punt it. Tina, this has been a blast. Where do people find out more info on what you’re up to, your writings, your goings ons, what you’re thinking about, New Guinea and Mozambique and everything else? Where do they go?
Tina:
Well, gmo.com obviously. On the splash page is all the research that’s written, and you can filter down to the emerging debt group and find us. We don’t write a ton of stuff that we send out that way, but we’re a friendly group. You can get in touch with us.
Meb:
Tina, thanks so much for joining us today.
Tina:
Thanks for having me.
