Hedge Manager buy credit default swaps that pay off if Japan and China have big problems

In an interview with Bloomberg Markets magazine, hedge fund specialist and Eclectica founder Hendry warned Japan is a ‘nuclear bomb’ strapped to the global economy, while China could collapse by 2015. Hendry is continuing to buy credit default swap protection on corporate bonds issued by Japanese industrial names as a play against China. He believes the Chinese economy is threatened by softening export demand, falling asset prices, and wild speculation in the real estate market. In response, veteran investor Bolton, the manager of the Fidelity China Special Situations trust, acknowledges China faces challenges, but says these do not outweigh the country’s bull points.

If Japanese corporate bond CDS spreads widen to equal or surpass their record highs of 2009, Hendry’s fund could rise by as much as 50% percent, he believes.

Hendry is making bold predictions and backing it up with a lot of money. He is also trying to talk up the risk premiums which will help him make money even if the negative cases do not materialize. Hendry is a hedge-fund manager beat who more than 80 percent of his peer group rivals in 2010.

Hendry has a track record of profiting from disaster with Eclectica, which bets on trends such as currency swings and interest-rate movements. One of Hendry’s major trades in 2010 was to purchase options on interest-rate swaps that bet on the future course of the Bank of England’s benchmark lending rate. The value of those contracts should rise if the market expects that the central bank will keep borrowing costs at or near historic lows.

Hendry isn’t always right. In 2006 and 2007, before the financial crisis, his flagship hedge fund underperformed the HFRX Macro Index, a benchmark of rival funds. In 2009, when funds tracking the S&P 500 returned about 23 percent, Hendry lost 8 percent — his worst performance since the fund’s inception, although the HFRX Index fell 8.8 percent in the same period.

“I see Japan as a nuclear bomb strapped onto the chest of the global economy. They have got uranium – which is, they sell credit protection: CDSs. I am the other side of that.”

In October last year Hendry initiated a substantial short position in Japanese credit as a way of playing the “vulnerable” Chinese market.

He dismissed the idea the Chinese engine of growth is unstoppable, and looked to profit from taking protection on industrially cyclical Japanese corporate credit.

Speaking to Investment Week at the time, Hendry said: “I cannot argue with Japanese government bonds being priced where they are today, the country has to deal with endemic deflation. What I cannot agree with is credit near zero, the world is always risky,” he added.

“I met the businesses where I have sought protection against their credit and it is tough to hear the current message. A lot of the companies are performing strongly; they are selling a lot of their products and are committing to more capital expenditure. However, these companies never invest at the bottom at the bottom of the cycle.

Now Hendry’s view on China has become even more downbeat, as he fears GDP growth in the the world’s second largest economy is not matched by wealth creation at home.

His worst case scenario is that a plunge in Chinese stock prices and property values will be exacerbated by a softening demand for the country’s exports, triggering an extended period of global deflation and slower growth.

Hendry’s bets on Japan have a time horizon of between two and five years, indicating that he expects China to crash sometime before 2015.

However, Bolton says he is not concerned about Hendry’s predictions, Bloomberg reports.

“I am not sure it is going to be all plain sailing in China,” says Bolton. “Hugh Hendry is worried about the bad debts from local governments and bad debts from other areas and the fact that some of the infrastructure spend is going into projects that will not see a return for many years. These are all challenges, but I do not think they overweigh the bull points.”

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