Hedge Fund Manager Hendry Bets on Deflation With U.K. War Loans

Date: Monday, December 1, 2008
Author: Tom Cahill, Bloomberg

Hugh Hendry, who oversees about $500 million as co-founder of Ecletica Asset Management in London, said he’s buying World War I debt on the bet the U.K. is due for its worst round of deflation since the Great Depression.

The gilts, known as perpetuals because they have no maturity date, have a coupon of 3.5 percent compared with the U.K.’s 4.5 percent inflation rate. Investors hold about 1.9 billion pounds ($2.9 billion) of the securities that still pay interest 90 years after the end of the Great War, according to the U.K.’s Debt Management Office.

“If you have a deflationary shock, the only instrument that will perform will be government debt,” said Hendry, 39, whose Eclectica Fund returned 38 percent this year, putting it in the top 1 percent of 1,817 funds tracked by Bloomberg. “Inflation is going to be back some day. But forget the next 12 years; it’s the next 12 months that matter.”

The Bank of England lowered its benchmark interest rate by 150 basis points last month, its biggest move in 16 years, as the credit crisis pushes the country’s economy into recession. Governor Mervyn King told lawmakers last week that failure to get banks lending again could raise the risk of deflation. As interest rates drop and investors shun risk, even government debt with a low coupon will rise in value, Hendry said.

The five-year breakeven rate, a gauge of inflation expectations as measured by the difference in yield between regular bonds and index-linked debt, has been negative for more than month, suggesting investors are betting a recession will lead to deflation. The gauge fell to minus 102 basis points today; it was at positive 105 basis points at the start of last month.

‘Jolly Long Bond’

The “Jolly Long Bond,” as Hendry calls the war loan, will be the most reactive to deflation because not having a maturity means it has long duration, said Charles Diebel, head of European interest-rate strategy at Nomura International Plc in London. A bond with a higher duration will increase more in value than one with a shorter duration for a given decline in yield.

“His philosophy behind it makes a lot of sense,” Diebel said. “If you have an extended period of time where inflation is not a problem, you get no yield at the front end of the curve and people will be forced out the yield curve. You can’t be forced out further on the yield curve than a perpetual.”

A yield curve is a chart of yields on bonds of a range of maturities. Longer-dated bonds typically yield more than shorter- dated notes to compensate investors for the risk of holding them over time.

The bonds trade so infrequently Hendry said he bought them for his personal account, rather than for the funds he manages.

“You’d become a bit of a hostage” by holding too much of a rarely traded bond like the perpetual, he said. “Managing a hedge fund means reserving the right to change your mind all the time.”

The biggest risk to the investment is inflation, which Hendry said ultimately will return because of the actions policymakers are taking today to thaw credit markets.

‘Help Your Country’

The U.K. government sold the perpetual in 1917, as British forces deployed tanks at the Battle of Cambrai, to repay loans it had sold since the conflict started in 1914. It marketed the debt with advertisements playing on patriotic sentiment.

“If you cannot fight, you can help your country by investing all you can in 5 percent exchequer bonds,” the advertisements said, according to an account in “The Financiers and the Nation,” by Thomas Johnston. “Unlike the soldier, the investor runs no risk.”

The 1917 notes were first sold with a coupon of 5 percent, a rate Prime Minister Lloyd George regarded as “penal,” according to Johnston’s book, first published in 1934 and republished by Ossian Publishers Ltd. in 1994. Neville Chamberlain, then Chancellor of the Exchequer, cut the coupon payment to 3.5 percent in 1932, where it has remained ever since.

The U.K. is unlikely to call the debt or retire it early because it would have to buy the bonds back at par, Hendry added. The gilts trade at about 78 pence today.

“The vast majority of this is locked up with retail investors,” said Diebel. Were the government to call the loans “they would be taking it away from households, rather than banks,” he added.

To contact the reporter on this story: Tom Cahill in London at tcahill@bloomberg.net