Tag Archives: alternative

Brazil’s Bond Yields Scream ‘Default!’

Summary Brazil’s government bond yields are at 14.8% – one of the highest among emerging markets. The Brazilian real has depreciated over 38% against the dollar due to capital flight. High interest rates may deter future capital flight. Brazil’s economy is contracting while its dollar-denominated debt is appreciating vis-a-vis its local currency. Brazil’s interest rates are higher than Venezuela (10.5%), though Venezuela’s debt is at junk levels. Brazil’s bond yields scream “default” and I believe them. Emerging markets are in the doldrums. Their currencies are falling, capital flight has taken hold and commodities — the main source of revenue for many — are in free fall. China’s recent currency devaluation amplified the situation. China is one of the biggest importers of everything from copper to steel to oil to iron ore; those products are now more expensive in China. Secondly, the devaluation was a de facto admission that the country’s economic growth is slowing — a bad omen for its trading partners. Selected Bond Yields In attempting to find the emerging country with the most risk, I looked at bond yields of selected countries – China, India, South Africa, Venezuela, Russia and Brazil. Brazil has the highest interest rates at 14.8% followed by Russia (11.9%) and Venezuela (10.5%). China has the lowest yields at 3.3%. Brazil is heavily dependent upon iron ore and oil in order to generate revenues. Oil is off 60% from its Q2 2014 peak and iron ore prices are 70% off their 2013 peak. Brazil’s economy contracted 1.9% in Q2 and the government is forecasting a budget deficit for the year. The country’s debt-to-GDP is about 65%, but could rise rapidly given its penchant for issuing debt in dollar-denominated currencies. According to the Wall Street Journal , Brazil has borrowed about $188 billion in dollar-denominated debt since 2008; it is second only to China’s $214 billion. Since Brazil’s currency is depreciating against the dollar, its debt-to-GDP could become untenable. Moody’s recently downgraded Brazil’s debt to Baa3 from Baa2 — one level above junk status. Another downgrade could be coming if its debt-to-GDP ratio amps up. Given 14.8% bond yields, that downgrade may already be priced in. Russia is heavily dependent upon oil and has been hard hit by economic sanctions from the U.S. and the EC. It has also engaged in conflicts to re-unify parts of the old Soviet Union, which has been costly. Like Brazil, Venezuela is heavily-dependent upon iron ore and oil to generate revenue. Declining commodity prices caused Venezuela to record a current account deficit in 2015 — the first time in nearly two decades. Currency Depreciation Currency depreciation against the U.S. dollar could be one measure of the amount of capital flight a country is experiencing. Russia’s currency depreciated 45% over the past year. Brazil’s is next at 39%. Given economic sanctions against Russia, the fact that it is at war Ukraine and is expected to make further incursions into Europe, it is almost foolhardy to maintain capital there. The depreciation of the real has been caused by capital flight to more stable currencies. At 3.76 against the U.S. dollar, the real is now at its lowest level since September 2002: (click to enlarge) I believe Brazil’s bond yields and currency depreciation are linked for the following reasons: Brazil Is In A Recession Brazil’s economy is contracting which may hurt its ability to repay its debt. Bond investors demand a higher premium for the risk of default — thus the high bond yields. Investors are also becoming more risk averse, thus capital is leaving Brazil and other emerging markets for the U.S. Higher Interest Rates Needed To Deter More Capital Flight 10 Year treasuries in the U.S. yield 2.14%. The Brazilian government may need to pay the 1,261 basis point differential between Brazilian bonds and U.S. treasuries in order to deter more capital flight. Brazil’s foreign currency reserves declined from $337 billion in August 2014 to $368 billion in July 2015. This will be a much-watched figure going forward. For instance, Venezuela only has about $17 billion in foreign exchange reserves so it is considered to have a higher default risk than Brazil. Dollar-Denominated Debt Payments Could Drain FX Reserves The more the real declines against the U.S. dollar, the more currency Brazil will need in order to pay interest and principal on its dollar-denominated debt. Those payments could be further strain on Brazil’s economy and budget deficit. If the U.S. raises interest rates, it will [i] drive more capital flight from emerging markets to the U.S. and [ii] force Brazil to pay more interest on its government bonds to keep capital at home. At some point it may become pure folly for Brazil to pay back dollar-denominated debt which is growing at double digits simply due to a depreciating real. It may behoove Brazil to default , thus its interest rates are so high. Brazil pays higher interest rates than Venezuela (10.5%), despite the fact that Venezuela’s bonds are rated at junk levels (Caa3) by Moody’s. Conclusion Brazil’s bond yields are screaming “default!” I believe them. I am short the ETF (NYSEARCA: EWZ ). I am also short Brazilian oil giant Petrobras (NYSE: PBR ) which has been hurt by a corruption scandal and lower oil prices, and is also exposed to dollar-denominated debt. This article may also impact the following securities: (NYSEARCA: BRZU ), (NYSEARCA: BZF ), (NYSEARCA: BZQ ), (NYSEARCA: BRAQ ), (NASDAQ: FBZ ) and (NYSEARCA: UBR ). Disclosure: I am/we are short EWZ, PBR. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Ignore Buffett: Refiners Are A Low-Quality Industry About To Plunge

Refining companies have been all the rage in 2015. After a brief lull, Buffett reignited passion for the sector buying a stake in Phillips 66. Ignore the hype, refiners are at the top of a cyclical boom. Aggressive investors should consider shorting the sector during this period of high volatility. So refiners are back in the news. They’ve been the toast of the town for much of 2015 as strong margins have driven rocketing share prices. Refining margins started plunging recently, and the stock market dumped; the one-two punch knocked the refining space down pretty hard. Predictably, lots of folks are running around calling it a big buy the dip opportunity. These calls are getting louder now that Warren Buffett has announced owning a large stake in Phillips 66 (NYSE: PSX ). He bought a stake worth roughly $4.5 billion, not chump change, even to a company as large as Berkshire Hathaway (NYSE: BRK.A ) (NYSE: BRK.B ). Buffett’s track record with energy is mixed. PetroChina (NYSE: PTR ) was a huge win for him, Chevron (NYSE: CVX ) and his dive into Energy Futures bonds were large mistakes that caused big losses for his company. His recent buy on Exxon (NYSE: XOM ) was extremely poorly timed, but he had the good sense to sell before it turned into another large loss. While I think buying refiners now is a terrible idea, I’ll give Buffett and his Phillips 66 a pass. Phillips is rapidly moving into other segments that are less vulnerable to the feast and famine dynamics of the refining industry. This is good because the refining industry stands like a shaky rig staring down a class four hurricane just miles away. Refiners have had a big boom since 2010, largely driven by expanding margins. Alas, these refining booms never last, this industry is a cyclical money pit that ends up having the same sort of returns that only fare well compared to, say, airlines or asteroid mining schemes. Just to be clear, this industry is about as far as you can get from anything suitable for buy and hold investors. It’s very much a trader’s paradise, buy when these companies are on the brink of bankruptcy, sell when people get euphoric again. Take the long-term 35-year chart for Tesoro (NYSE: TSO ), one of the more competent and (occasionally) beloved pure-play refiners. (click to enlarge) In 1980, yes, back when disco was still a respectable trend, Tesoro shares traded as high as $16. They then did nothing for the next 12 years, falling as low as $1.37 in 1992. Refining entered one of its periodic booms, sending shares up 8x to $10 in 1998 – still well short of where it was back in 1980. Then disaster hit on the next cyclical collapse, sending shares as low as 62 cents in 2002. That’s a miserable return on investment since 1980, a 96% capital loss over 22 years! And to be clear refining is a capital intensive industry, these guys only pay acceptable dividends (for short periods of time) during sector peaks, followed by long periods of abolishing the dividend all together while they’re in “avoid bankruptcy” mode. You’re not getting paid to wait owning these guys while their stocks go sideways decades at a time. After 2002, fortunes turned brighter with a big increase in gasoline demand as the SUV craze hit. As gasoline usage surged, refiners suddenly (finally) found themselves with excess demand for their industry, and margins soared. Tesoro shares would go on a monster run, clocking out a 100x return for anyone that bought near the low. Shares peaked in the 60s in 2007 and then started to dive. In 2008, as the economy started to sink and rising oil prices killed consumer demand for gasoline and other refined products, the refineries started another classic bust. Shares, which started the year at $45 in 2008 fell as low as $6 by that winter, a stunning 85% one-year collapse – a dive so steep, it put most of the banks to shame. Remember, if you paid $16 a share in 1980, at this point, you’re still sitting on a 60% loss, 28 years later – and Tesoro is a refining industry leader. Just think of how the lower-quality refiners did over that three decade span! In 2010, refiners started to recover, aided at first by some timely hurricane activity and then by the rise of US oil production. The glut of US oil produced by the domestic energy boom caused a massive oversupply of oil locally compared to the world market. This resulted in boom times for the US refineries, which suddenly got to enjoy cheap input fuels while the value of their refined products including gasoline, heating oil, and jet fuel remained robust. The recovering economy also helped on this count. Alas, the refining boom of 2010-2015 has died. They’re engraving its tombstone as we speak: “He had a great run, but in the end the oil bust and Chinese commodity collapse was too much for his aging heart to bear.” The refining boom was fueled up primarily by three factors. The glut of US oil, the improving US economy, and the lack of new refineries. All three of those factors are played out. As you know, oil prices have collapsed this past year. This is placing intense strain on US-based marginal oil producers. There’s a ton of data that disputes exactly where the break-even for a US shale project is, but it’s clearly north of $45 where we are today. There’s talk that US production isn’t falling yet, contrary to expectations, since capital-constrained players have to keep producing. Yeah, I acknowledge we may not see US domestic production fall straight off a cliff, but let’s be straight here, there’s no reason to expect US oil production to remain at these elevated levels. Capitalism stops unprofitable activity from continuing sooner than later. Lower prices will cause lower levels of production sooner or later, basic economics assures us of that. And US suppliers, as some of the higher marginal cost producers, will be among the first to shut up shop. When they do, the disparity of prices in between WTI and Brent crude, and particularly in discounted Midwestern crude that companies like Western Refining (NYSE: WNR ) have used to great advantage will fade. The refining boom was largely built on getting access to below normal market priced crude and letting all that extra margin soak through to the bottom line rather than going to consumers. That’s why you’ll not be seeing gas nearly as cheap as you expected at the pump with oil plunging. Another cause of higher margins has been that the US refining industry was capacity restrained. No new refineries had been built in 30 years, and many of the country’s refineries were shut in the 1980s when there was excessive capacity. The sudden appearance of the shale boom suddenly caused the nation’s refining stock to be insufficient to process all the country’s oil output. However, for the first time in ages, new refineries are being built in the US, which will add supply to the industry, putting pressure on margins. Additionally, there were an unusual number of strikes and explosions in refineries in early 2015 that put transitory upward pressure on margins. This boost is now dissipating. And finally, the economy had been improving in the US and neighboring regions that also consume US-refined petroleum products, namely Mexico and Canada. Canada now appears to be heading into a serious recession, and Mexico, while still growing economically, is sputtering. And the US economy is definitely decelerating, with the Fed threatening to tighten monetary policy as the domestic economy struggles and emerging markets are crashing. Sure enough, the crack spread has absolutely collapsed, falling from near 30 just a couple of weeks ago to the 15s today. It plunged during the market dive, and has continued diving this week, down 15% Monday, and another 5% Tuesday. To be clear, the crack spread is what butters the bread for refineries. The crack spread is the difference between their input crude and the output products such as gasoline, and fuel oil. Sure refiners can hedge, some have more exposure to other products like asphalt or specialty products, and whatnot. But that spread in general drives the industry. Notice how quickly refining stocks surged this spring when the spread shot upward. Now with it plunging again, refining stocks are likely to resemble falling anvils in coming weeks. Given the end of the conditions that caused the refining boom in the first place, there’s no reason for these stocks to have bids anywhere near these levels. Tesoro, for example, is trading at 9x cycle peak earnings levels. Analysts estimate earnings will drop by $4/share in 2016 to less than $8/share. That alone is eye-catching, you never want to see a company shed $4 in earnings power in a single year. Consider this : in 2009, Tesoro lost 87 cents a share, it lost a penny in 2010, made $4.02 in 2011, $6.20 in 2012, and then earnings plunged by more than 50% to $2.85 of EPS in 2013. Do you think that company’s current $10+ EPS earnings power is a permanent improvement, or a passing fad caused by a now-expired domestic oil boom? If EPS goes back to $2.85, like they earned in 2013, let alone making losses as they did in 2009-10, what would the stock be worth? The current $90 share price is a more than 30x multiple on earnings from just two years ago. Unless you think the domestic refining industry has entered a period of permanent bliss, despite all signs pointing to the contrary, paying 9x the unusually high current earnings is simply myopic. That refining stocks haven’t collapsed faster is a bit surprising. Perhaps they’re benefiting from the best house standing in a bad neighborhood effect. Previously, the “smart money” was flowing to the pipeline players such as Kinder Morgan (NYSE: KMI ) causing them to become substantially overvalued. I pointed this out this spring, Kinder shares are down sharply since then. Now that investors are scared out of pipelines, refiners are pretty much the last energy house that hasn’t collapsed. But their industry fundamentals have turned sharply negative, and profit margins have imploded in the past month. To sum up, here are long-term charts of two more pure-play refiners, Western and Valero (NYSE: VLO ). Western, a favorite of mine at $6 in 2008, but absurdly overvalued nowadays: (click to enlarge) And here’s Valero, the industry bellwether: (click to enlarge) Note how terrible these investments are over time – it truly is a miserable industry, like airlines for long-term holders. See where we were in 2007 when the SUV-driven refining craze ended? Yeah, that’s about where the refining industry is now. Take note of what happened next. Do your own diligence before following Buffett blindly into the refining sector. Disclosure: I am/we are short TSO, WNR. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

EMB Offers Investors An Interesting Play On Credit Risk With Mixed Durations

Summary The portfolio for EMB is heavy on bonds that are just barely investment grade. The maturity of those bonds is heavily diversified but the one empty part of the curve is short durations. A mixed duration on the bonds allows it to have a positive correlation with medium-term treasury ETFs. Despite the positive correlation with treasuries, it also has a positive correlation with the equity markets due to the credit risk exposure. The iShares J.P. Morgan USD Emerging Markets Bond ETF (NYSEARCA: EMB ) is a very interesting option for investors wanting to add some new exposures to their portfolio. There are plenty of reasons for investors to be worried, but it remains an interesting allocation for a small part of the portfolio. Expense Ratio The expense ratio on EMB is .40% which feels like it would be typical for finding exposure to a somewhat niche market like investing in the bonds of emerging markets. That would probably be a fair assessment as well. While Vanguard also runs a fund in this niche market, the Vanguard Emerging Markets Government Bond Index Fund ETF (NASDAQ: VWOB ), the expense ratio in that fund is .34%. While there is a difference in the expense ratios, the difference is not very substantial. While EMB does have a higher expense ratio, it also has more than ten times the average volume with around 1.3 million shares per day changing hands compared to a hundred thousand for VWOB. Since shares of EMB are more expensive, adjusting for the difference in price would only extend the liquidity advantage of EMB. Credit Ratings The credit ratings on bonds in the portfolio can be seen below The majority of the bonds can be considered investment grade since the heaviest position is in the BBB rated bonds. However, it should be clear that there is still a substantial weighting to investments with lower credit ratings and this portfolio should be seen as being a fairly aggressive debt investment and share prices could be hit from factors as simple as an increase in the credit spread between riskier bonds and treasury securities. Maturity The following chart shows the maturities: This portfolio is incredibly diversified in the maturity of the securities. However, since the diversification includes a very material allocation over 20 years and very little at the shortest end of the yield curve it would be wise for investors to keep in mind that they are facing both substantial credit risk and duration risk. That makes this an interesting ETF for investors trying to optimize their portfolio for low volatility. Building the Portfolio This hypothetical portfolio has a slightly aggressive allocation for the middle aged investor. Only 30% of the total portfolio value is placed in bonds and a third of that bond allocation is given to emerging market bonds. However, another 10% of the portfolio is given to preferred shares and 10% is given to a minimum volatility fund that has proven to be fairly stable. Within the bond portfolio, the portion of bonds that are not from emerging markets are high quality medium term treasury securities that show a negative correlation to most equity assets. The result is a portfolio that is substantially less volatile than what most investors would build for themselves. For a younger investor with a high risk tolerance this may be significantly more conservative than they would need. The portfolio assumes frequent rebalancing which would be a problem for short term trading outside of tax advantaged accounts unless the investor was going to rebalance by adding to their positions on a regular basis and allocating the majority of the capital towards whichever portions of the portfolio had been underperforming recently. (click to enlarge) A quick rundown of the portfolio The two bond funds in the portfolio are for higher yielding debt from emerging markets and (NYSEARCA: IEF ) for medium term treasury debt. IEF should be useful for the highly negative correlation it provides relative to the equity positions. EMB on the other hand is attempting to produce more current income with less duration risk by taking on some risk from investing in emerging markets. The position in (NYSEARCA: USMV ) offers investors substantially lower volatility with a beta of only .7 which makes the fund an excellent fit for many investors. It won’t climb as fast as the rest of the market, but it also does better at resisting drawdowns. It may not be “exciting”, but there are plenty of other areas to find “excitement” in life. Wondering if your retirement account is going to implode should not be a source of excitement. The position in (NYSEARCA: PKW ) makes the portfolio overweight on companies that are performing buybacks. The strategy has produced surprisingly solid returns over the sample period. I wouldn’t normally consider this as a necessary exposure for investors, but it seemed like an interesting one to include and with a very high correlation to SPY and similar levels of volatility it has little impact on the numbers for the rest of the portfolio. The core of the portfolio comes from simple exposure to the S&P 500 via (NYSEARCA: SPY ), though I would suggest that investors creating a new portfolio and not tied into an ETF for that large domestic position should consider the alternative by Vanguard (NYSEARCA: VOO ) which offers similar holdings and a lower expense ratio. I have yet to see any good argument for not using or another very similar fund as the core of a portfolio. In this piece I’m using SPY because some investors with a very long history of selling SPY may not want to trigger the capital gains tax on selling the position and thus choose to continue holding SPY rather than the alternatives with lower expense ratios. Risk Contribution The risk contribution category demonstrates the amount of the portfolio’s volatility that can be attributed to that position. To make it easier to analyze how risky each holding would be in the context of the portfolio, I have most of these holdings weighted at a simple 10%. Because of IEF’s heavy negative correlation, it receives a weighting of 20%. Since SPY is used as the core of the portfolio, it merits a weighting of 40%. Correlation The chart below shows the correlation of each ETF with each other ETF in the portfolio and with the S&P 500 . Blue boxes indicate positive correlations and tan box indicate negative correlations. Generally speaking lower levels of correlation are highly desirable and high levels of correlation substantially reduce the benefits from diversification. Conclusion When EMB is measured simply on the annualized volatility it does very fairly well. However, the difficult part about having mixed duration emerging market debt is that the poor credit rating encourages the portfolio to have a positive correlation with the market. If an investor is trying to minimize volatility they may be using a position in medium or long term treasury ETFs which would create some overlap on the long duration exposure but at very different credit ratings. Simply put, EMB manages to have positive correlation with both the market and with the treasury securities that have a negative correlation with the market. I like this bond space, however due to the strange situation with the correlations I would lean toward using it as a small portion of the portfolio. In this example I used it at 10%, but I suspect that 5% might be a more reasonable way to allocate it into the portfolio. Overall, you could say I find more things to like than dislike, but I would still limit the size of the exposure. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.