How to profit from an unbalanced relationship

Multi-currency debt management can be a useful tool in running a high net worth client’s portfolio, making good use of borrowing power and capital gains. Elizabeth Cripps reports.

For high net worth individuals, multi-currency debt management adds a new dimension to portfolio planning. Michael Petley, chief executive at currency debt specialist The ECU Group, subsidiary of the world’s largest alternatives manager, ED&F Man, maintains that this will become an established asset class. He predicts currency debt will boom in the same way that hedge funds have proliferated in the wake of equity fund managers’ indifferent recent performance. Essentially, multi-currency debt management reduces debt in the foreign exchange markets (Forex) by identifying currency relationships that seem out of balance, thereby allowing investors to leverage on an existing portfolio in a relatively safe way. Debt is swapped into the currency that is perceived to be weaker, with a profit or loss being realised when the debt is returned to the original (or reference) currency. Multi-currency debt management is market neutral, with no direct or performance-related correlation to either interest rates or stock markets. Over a five-year period, the ECU Group has made returns of 46 per cent on its sterling product. “For the past 40 years, debt has been eroded by inflationary forces,” says Mr Petley. “In a low inflation environment, debt begins to weigh far more heavily for all types of borrower.” The value of debt increases in areas where deflationary forces have gained the upper hand, he says. With deflation looking as though it will be a growing force in the future, alternative methods of actively “managing down” and reducing debt burden can be expected to become increasingly popular. Firm grasp of risk Take, for example, a high net worth individual (HNWI) with a portfolio of E500,000. Before he/she hires a debt manager, says Mr Petley, he/she must have a firm grasp of the risks involved, demonstrate that understanding to the manager and establish clear parameters about what level of risk is to be acceptable. That established, the process of multi-currency debt management is twofold. Banks – normally private banks – do the lending while management houses, such as ECU, do the managing. The exact lending conditions may differ from bank to bank; when it comes to the managing, the HNWI needs to establish both the borrowing power of her assets and how much she should, or could, borrow against them. Prudential borrowing power depends on qualifying securities. The general borrowing power of the HNWI’s E500,000 could, therefore, be a combination of the possibilities outlined by ECU in Table one. In terms of suitability for collateral, Mr Petley points out that a bond portfolio is a better bet. “Investment grade bonds release more borrowing power,” he says. “And, in the main, bonds rated BBB+ and above have stable market values, subject to issuer credit conditions.” The combination of a bond portfolio and a multi-currency debt management programme has the further bonus of being able to mitigate a sharp rise in the HNWI’s reference currency, says Mr Petley. Ordinarily, the reference value of bonds in the portfolio denominated in the foreign currency would fall under those circumstances. “Multi-currency debt management can also release equity from an existing bond portfolio that was constructed when yields were much higher, alleviating any need to sell performing bonds and facilitating an attractive proposition of gain in another non-stock market related asset class,” he says. Sample portfolio If the HNWI puts 20 per cent of his/her E500,000 in government debt, 40 per cent in corporate debt, 20 per cent in equity and 20 per cent in funds, his/her borrowing power would be that outlined by ECU in Table two. “In other words, against a balanced portfolio of E500,000, a total of E663,000 of borrowing power is released that could be placed on money market deposit, with the resultant debt being managed by a debt manager,” says Mr Petley. “To achieve these levels of borrowing, the borrowed cash would remain on money market deposit with the lending bank. It could not be withdrawn but it might be invested into acceptable collateral instruments.” The multi-currency manager then manages the debt by selecting the currencies in which the borrowing is to be done. “When the debt is in a currency other than the reference currency, interest repayment will be in that currency. This means that there will be a differential between the yield derived from the cash on deposit – in the reference currency – and the cost of funds charged on the foreign exchange debt that has been selected for its weakness potential,” says Mr Petley. “If the debt currency is a low interest currency, such as the yen, interest rate savings will be achieved, as the lending spread will be partially or completely absorbed by the interest rate carry differential. If the debt is in a higher interest currency, such as sterling, then there will be more interest to pay.” Capital gain is achieved by trading between the currencies. With major currencies, although there is volatility between them, Mr Petley argues that lower interest rates mean a higher likelihood of covering the cost of debt from capital gain. Large interest rate differentials between the major currencies are less common than in the past, he says. The spread of approximately 3.75 per cent between the yen and sterling is the greatest, and much lower than previously, reflecting “the greater uniformity of inflationary pressure”.