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The real carry trade

If you buy into the emerging-market growth and commodities stories, maritime investments could offer another way to diversify your exposure, writes Martin Steward

The original ‘carrying trade' had nothing to do with going short yen and long Aussie dollar. It was, wrote Adam Smith, "purchasing goods in one foreign country in order to supply the consumption of another". It is serious business: the world's 55,000 ships generated $600bn (€432bn) in revenue last year by transporting some 90% of global trade.

Historically, the growth of shipping has leveraged global GDP growth two times. But we all know what has happened to growth and trade recently: the Baltic Dry Index (BDI) of prices for transporting various dry bulk cargoes on different routes around the world collapsed 98% from its peak in May last year to its trough in December. The average daily rate for a capesize (a vessel size classification) vessel was $230,000 last June; by April you could lease one for $17,000 per day. Just like a company, a ship's market price is the present value of its future cash flows: a shipowner can hire a vessel out for up to six months for a single voyage (the ‘spot' market) or longer (the ‘time-charter' market); and the BDI is an index of the charter rates. That makes valuation surprisingly transparent and standardised - around 40-50 ships are traded each week, and in addition to the BDI, weekly brokerage reports giving charter rates for a range of vessels go back a generation - but it also means that when the BDI crashes the market value for vessels usually follows. A capsize fetching $150m last summer would now struggle to clear $50m.

That could make this a good entry-point for a long-term investor who still buys into the emerging markets growth story. "From a risk-adjusted return perspective we are getting in at a significant low," as one managing director at an institutional asset management firm that is building a maritime investment platform puts it, "and in many cases the market has bottomed-out".

If this was just about a one-for-one correlation with economic activity, timing that entry would be simple. Dry bulk carriers should see demand first, as infrastructure projects benefit from stimulus packages; tankers should follow a few months later as economic recovery boosts oil demand; while containers transporting finished goods have to wait on the beleaguered consumer. But investors have to be aware of two cycles: macroeconomics and ship supply and demand. Tim Coffin, a fund manager with maritime hedge fund M2M Management, points out that tankers could surprise relative to dry bulk because new legislation requiring double-hulled vessels is speeding-up the scrapping process. But there is downside risk, too. "You can have a booming economy, but if you have too many ships returns will be low."

Everyone agrees that containers are suffering serious over-supply, but in general predicting dynamics is tricky: many existing orders will end up being cancelled, because they were booked for shipyards which themselves remain unbuilt; or booked on an assumption of financing - advance rates of 65% were the norm - that simply isn't available. RBS alone is reducing its exposure by 30% - $10bn that buyers are going to have to find somewhere else. Add this to collapsing charter and residual values and you get a toxic mix: an owner who bought a panamax (another size classification) in spring 2007 with $25m equity and $45m debt has seen the value of that ship come down to $30m; meanwhile the $70,000 per day he could command when he bought has dropped to $14,000 per day; the overall effect is an asset that is losing money at an annualised rate of $4.6m. For a portfolio of 15 ships that is a serious cash flow problem - the last thing that shipowner is thinking about is adding to that portfolio. Sure enough, 2008's $550bn order book has shrunk to $360bn thanks to cancellations.

In theory this ability to self-correct is what prevents this market from becoming truly distressed. But the damage done to the big liner companies creates a new opportunity for unleveraged, cash buyers. Pension funds could find themselves in the market with wily old Greeks with sea salt in their veins: "For the first time in a generation we are seeing the old-time shipping guys get their wallets out," says Coffin. No wonder: that panamax bought at $30m and chartered for $14,000 per day will generate a 12% annualised return over five years, even if values and rates remain static.

"There's a big problem funding deals that have already been done, and that's a great opportunity for newcomers," says Tony Foster, CEO of Marine Capital, which is raising funds to construct a portfolio of vessels. "We recognised that the large European pension funds are our natural market."

How does the asset class fit a pension portfolio? It beats inflation over the long term, as its link into commodity and consumer markets suggest. "If you are involved in commodities, you should also be very aware of what is happening in freight," as Wilhelm Meier, founder of HF Navigator, the exclusive investment adviser to the Aquila Capital Okeanos Shipping Fund, puts it. He should know - he worked in the grains industry for 30 years. The cash flow element results in a profile that resembles a short-duration, high-coupon bond; but with low correlation to financial assets. As Foster observes, this makes it an excellent solution to close an asset-liability gap in short order, particularly while interest rates are in a rut.

But is it any use for longer-term liability hedging? You could enter into longer time-charter arrangements, locking in future cash flows without taking excessive duration risk. The downside, Foster says, is greater counterparty risk. Instead it might be better to exploit the industry's debt market - Marine Capital estimates that 20% of the $500bn market is likely to be up for sale.  "Liquefied natural gas carriers are typically financed on a 25-year basis," he notes. "So you could buy a package of LNG carrier loans from a bank, effectively a long-duration bond - except it's a shipping deal and it's got a decent coupon."

Not everyone is bullish about returns from the high seas, or the ability of the market to self-correct quickly. Some insist that if the last decade's expansion of global trade was based on China selling to the US consumer to stock-up on US dollar reserves, then the correction of that global imbalance must also correct the trade multiple on GDP, which has gone from a long-term average of two-times to a recent peak of three-times.

"It's been a fantastic decade for shipping, but it's over," says Wollert Hvide, co-CIO of Sector Asset Management. "You can get exposure to GDP and inflation in better places than in shipping beta." He is not running down his own business: the Sector Maritime Fund is one of a number that regards shipping as a great source of alpha rather than beta - it trades relative value across shipping stocks, energy stocks and the freight forward agreements (FFAs), the industry uses to hedge risk. FFAs provide ‘time spreads' across their term structure; but also ‘basin spreads' (between different routes) and ‘size spreads' (between different types of vessel).

These trades make up 5% of Aquila's Okeanos Shipping fund, too. Another 25% is directional FFA, the rest arbitrages between FFAs and physical ships. The fund charters a ship; then it hedges this long-ships position with a short FFA position; fixes a voyage for the ship; and gradually closes out its short FFA position over the course of the voyage-period. The fund takes the spread between the charter rate it pays and its income from carrying the cargo, but in addition, because the FFA market tends to overshoot expectations, the short FFA also books a profit.

M2M's flagship Global Maritime Investments (GMI) fund pursues a similar strategy - the firm also runs an FFA-only fund and a new fund, Global Maritime Assets (GMA), that buys ships to charter-out, with FFAs against them. M2M likens shipowners to car-hire companies faced with potential clients who want taxi rides - their strategy effectively hires the car, charges end users a taxi fare and cuts itself a margin.

"For us that's too speculative. By trading FFAs we can typically add another 7-9% to shipping beta," observes Coffin, who co-manages GMA. "Our trading carries the fund through the bottoms, whereas most managers are thinking to buy some ships and go to bed for five years."

It is important to note that all of these alpha strategies have an element of directionality. "The trading strategy is basically neutral," explains Thomas Hartwig, head of risk management and trading for the Aquila fund, "but you need the FFA market to overshoot the direction you have taken with your physical exposure to get it right." The example above is a bullish spread - a bearish spread can be constructed with long-FFA, short-physical positions. Ultimately, then, these funds may fit best in an alternative investments bucket - although they can offer some exposure to shipping beta with very disciplined downside protection. For those who like the maritime story in principle, but prefer not to speculate on global GDP or its trade multiple, they may represent a prudent allocation.
 

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