Tag Archives: author

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.

Defensive Expectations

Any fund can do very well, attract a lot of assets, then do poorly and lose the assets. For many years, I have been writing about the idea that diversifiers often do not trade like the stock market and so can offer a zigzag effect to equity holdings. A fund that can make narrow bets on a specific outcome with a large percentage of assets lends itself to being very right or very wrong. By Roger Nusbaum, AdvisorShares ETF Strategist Last week there was an article in the WSJ noting the performance struggles of one of the larger liquid alternative mutual funds. I am not going to link to the article or name the fund because any fund can do very well, attract a lot of assets, then do poorly and lose the assets – which is the arc of this fund’s story. Instead, I want to focus on avoiding that sort of loop or at least recognizing the potential for that sort of loop, so that no one is surprised if/when it happens. For many years, I have been writing about the idea that diversifiers, as I have previously called them, often do not trade like the stock market and so can offer a zigzag effect to equity holdings that can matter during periods like now. There is no guarantee of this of course, but just as was the case with the previous bear market, some diversifiers will deliver and some will not. The fund featured in the above-mentioned article had problems that included a large bet on China that went poorly and was a drag on returns. One of the fund’s objectives is lower volatility than the broad market, yet based on stale holdings reported on Google Finance, three of its top-ten holdings totaling about 13% were in China. The fund did very well for a time early in the current decade, tracking the equity market closely, but started to trail off still moving higher in 2013 and then starting to go negative in early 2014 and has been in a downtrend for the majority of the time since then. Obviously, if Chinese equities had rocketed higher, then some or maybe all of the downturn could have been offset. This places an important emphasis to not just glance at the holdings but actually understand the pros and cons of any larger exposures. Are there a lot of longer-dated bonds in your liquid alternative? If so, are you concerned about rising rates, or can the fund change that exposure? What about commodity exposures or foreign currency? None of these are bad but they need to be understood and followed closely. Additionally, it is crucial to spend time understanding what the fund can and cannot do to change exposures and the process behind portfolio changes. A fund that can make narrow bets on a specific outcome with a large percentage of assets lends itself to being very right or very wrong. Very wrong in a bull market for everything else is probably not a big deal, but during a decline like this, then it is unfortunate. Gold has taken a beating from a sentiment standpoint for how poorly it has performed for the last few years. Throughout, I noted that it was doing exactly what investors should hope; looking nothing like the equity market, which created the reasonable expectation of not looking like equities in a downturn and that is how it has played out over the last month, as the S&P 500 is down mid-single digits and gold is up mid-single digits. It is not a perfect, negative correlation but has helped. The bigger context with a post like this has always been to try to soften the blow of a large decline, not completely miss it (completely missing it would be more about luck than strategy). I continue to be a believer in this approach, as a little bit can go a long way to reduce the extent to which the portfolio trades in line with the broad market. 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. I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: To the extent that this content includes references to securities, those references do not constitute an offer or solicitation to buy, sell or hold such security. AdvisorShares is a sponsor of actively managed exchange-traded funds (ETFs) and holds positions in all of its ETFs. This document should not be considered investment advice and the information contain within should not be relied upon in assessing whether or not to invest in any products mentioned. Investment in securities carries a high degree of risk which may result in investors losing all of their invested capital. Please keep in mind that a company’s past financial performance, including the performance of its share price, does not guarantee future results. To learn more about the risks with actively managed ETFs visit our website AdvisorShares.com . AdvisorShares is an SEC registered RIA, which advises to actively managed exchange traded funds (Active ETFs). The article has been written by Roger Nusbaum, AdvisorShares ETF Strategist. We are not receiving compensation for this article, and 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.