By NEIL SHAH, Wall street Journal, 10.2.2012
Last fall, as worries about Europe's banks mounted, Davide Serra fretted over the fate of Algebris Investments LLP, his $700 million hedge-fund firm.
Algebris had one-third of its money tied to stocks and bonds of European banks likeBanco Santander SA and Intesa Sanpaolo SpA. The investments tumbled in the final months of 2011, as Spain and Italy were engulfed in Europe's sovereign-debt crisis.
A former bank analyst at Morgan Stanley, Mr. Serra resolved to stand firm—even though his firm's performance was plunging and some clients wanted to exit. On Dec. 1, Mr. Serra told investors at a New York hedge-fund conference that he was confident that "by Christmas, we will have a solution" to Europe's debt troubles.
Three weeks later, the European Central Bank doled out nearly a half-trillion euros in loans to Europe's banks—a striking move that some investors thank for averting a global market crash.
"Things were hard, but we kept saying they won't let the system fail," Algebris's 41-year-old, London-based co-founder recalled.
This year's market rally has caught many investors by surprise. But a few traders who ramped up risky bets while others headed for the exits last year are seeing outsize gains. Their growing confidence suggests Europe's outlook could be improving—at least for now. In the latest sign of progress, Greek political leaders Thursday agreed on key steps that should pave the way for a second bailout from the European Union and International Monetary Fund, and the euro reached its highest level since early December.
Mr. Serra is part of the band of fund managers who bet on Europe during the depths of its financial crisis and survived to tell the tale. The group of contrarian investors, a minority when compared with the large swaths of fund managers who steered well clear of the Continent, is reaping the benefits of the bold moves now.
Algebris, for example, lost 30% in 2011, partly thanks to its European bets. But its flagship fund, which buys stocks of European and global banks, is up 9.7% this year, while a separate fund specializing in risky bank bonds—about one-third European—has gained 24.3%. By comparison, the Standard & Poor's 500-stock index is up 7.5% this year, and the Stoxx Europe 600 index, measured in euros, has climbed 7.8%.
It isn't just Mr. Serra. Last summer, portfolio manager Michael Hasenstab at Franklin Templeton Investments, a U.S. money manager with more than $670 billion in assets, began buying Irish bonds in the belief that the government wouldn't default on its debt. According to Franklin, the bet totaled around €5.5 billion, or about $7.2 billion, as of the end of last year—a large wager given the size of Ireland's bond market, observers said.
“Things were hard, but we kept saying they won't let the system fail”Davide Serra, cofounder of a London hedge fund
Ireland has made more progress dealing with its debt problems than other struggling euro members, Mr. Hasenstab said. Irish 10-year-bond yields, which move inversely to their prices, were at 7.08% on Thursday, from more than 14% at their peak in July.
Sohail Malik, lead portfolio manager of European Credit Management's Special Situations Credit Fund, says a successful bet last December was buying the short-term senior debt of euro-zone banks. Such bonds in Portugal were especially attractive, giving investors yields of 15% to 18%, a level that dropped to 9% in January before rising back to about 11% recently. Mr. Malik said he has been trying to profit from the "momentum" generated by the ECB's recent measures.
Such trades are the latest sign that Europe's banking and debt woes are easing enough for money managers to start picking through the rubble for bargains. Last week, Italy's Intesa Sanpaolo became the first bank from a financially stressed euro-zone country to sell senior, unsecured debt in many months, helping relieve fears of a credit crunch for European banks. In late January, Ireland's government impressed investors by successfully entering the capital markets to extend the maturity of its loans.
Other investors remain on the sidelines or hold negative bets on the euro because of concerns over a European recession and Greece's ability to avoid a disorderly default.
Currency-focused hedge funds, for instance, are unconvinced by the euro's recent rally and have been slow to move their cash out of U.S. dollars—considered a safe haven—into riskier investments. "This has moderately hurt their performance in January," said Luca Avellini of JW Partners, a research and advisory firm that invests in 23 funds with a combined $20 billion under management in currency strategies.
For every George Soros, whose family fund bought about $2 billion in European bonds late last year, there is a Highland Capital Management LP, a $23 billion alternative-investment firm whose co-founder and president, James Dondero, believes Europe will avoid a banking crisis and a euro breakup, but that the Continent's financial assets are too risky.
Instead, he is championing U.S. stocks and high-yield "junk" bonds, risky financial assets whose prices could rise in lock step with European assets but that don't carry the stigma of European investments.
Highland's main credit hedge fund, Highland Diversified Credit Fund, ended last year up 6.4%, according to Hedge Fund Research Inc.
At Algebris, Mr. Serra is placing bets on riskier "subordinated" bonds of European banks. These bonds are riskier because, in the event of a default, holders recoup cash only after senior-bond investors are paid back. In September, Mr. Serra, who in the 1990s took a macroeconomics course from Italy's current prime minister, Mario Monti, bought a two-year bond from Spain's Banco Santander that offered a 16% yield. He also is holding a "contingent convertible" bond from Britain's Lloyds Banking Group PLC. Such "CoCo" bonds are risky because they turn into equity if the bank issuing them depletes a specific amount of capital. While the U.K. government is Lloyds's biggest shareholder, the country isn't part of the euro.
Investors increasingly believe Europe's rally could continue, although many of the region's economic problems remain unsolved. The ECB will offer more loans to banks at the end of the month.
Before the ECB's move last year, "you were guaranteed to have an accident somewhere," Mr. Serra said. "Now the accident is very unlikely to happen."
Write to Neil Shah at neil.shah@dowjones.com
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