Reach for Yield With Sovereign Debt

During my recent meeting with the senior portfolio managers of the big Swiss banks, I kept hearing the same word over and over: yield, yield, yield! The search for yield by end investors has become so overwhelming that it now trumps all other considerations. So I am starting a series of major pieces on the world’s best yield plays. Those include emerging market debt, REIT’s, master limited partnerships, and junk bonds.

The trick is to enhance your yields without taking insane amounts of risk to get there. In the summer of 2007, investors were accepting vast increases in principal risk in the junk market for a mere 100 basis point increase in interest payments over Treasuries. A year later, that spread exploded to 2,500 basis points. Needless to say, the portfolio managers who made that call are now driving taxis in some of New York’s least attractive neighborhoods.

I have had great luck steering people into the Invesco PowerShares Emerging Market Sovereign Debt ETF (PCY), which is invested primarily in the debt of Asian and Latin American government entities, and sports a generous 4.87%  yield (click here for their site). This beats the daylights out of the one basis point you could earn for cash, the 1.75% yield available on 10 year Treasuries, and still exceeded the 3.98% yield on the iShares Investment Grade Bond ETN (LQD), which buys predominantly single ‘BBB’, or better, US corporates.

The big difference here is that PCY has a much rosier future of credit upgrades to look forward to than other alternatives. It turns out that many emerging markets have little or no debt, because until recently, investors thought their credit quality was too poor. No doubt a history of defaults in the region going back to 1820 is in the back of their minds.

You would think that a sovereign debt fund would be the last place to safely park your money in the middle of a debt crisis, but you’d be wrong. (PCY) has minimal holdings in the Land of Sophocles and Plato, and very little in the other European PIIGS. In fact, the crisis has accelerated the differentiation of credit qualities, separating the wheat from the chaff, and sending bonds issues by financially responsible countries to decent premiums, while punishing the bad boys with huge discounts. It seems this fund has a decent set of managers at the helm.

With US government bond issuance going through the roof, the shoe is now on the other foot. Even my cleaning lady, Cecelia, knows that US Treasury issuance is rocketing to unsustainable levels (she reads my letter to practice her English). The ratings agencies have been rattling their sabers about further downgrades of US debt on an almost daily basis, and it is just a matter of time before this, once unimaginable, event transpires again. When it does, there could be a stampede into the debt of other healthier countries, potentially sending the price of (PCY) through the roof.
Since my initial recommendation, my total return on (PCY) has been 50%, not bad for an insurance policy. Money has poured into (PCY, taking assets up nearly tenfold to $2.13 billion over the last four years. Another name to consider in this area is the iShares JP Morgan USD Emerging Markets Bond (EMB)

I lived through the Latin American debt crisis of the seventies. You know, the one that almost took Citibank down? Never in my wildest, Maker’s Mark fueled dreams did I think that I’d see the day when Brazilian debt ratings might surpass American ones. Who knew I’d be trading in Marilyn Monroe for Carmen Miranda?

 

 

 

Time to Trade Her

 

For Her?