Sovereign Debt is a Great Place to Hide

madhedgefundtrader's picture

I am constantly asked where to find safe places to park cash by investors understandably unhappy with the risk/reward currently offered by the markets. Any reach for yield now carries substantial principal risk, the kind we saw, oh say, in the summer of 2007.

I have had great luck steering people into the Invesco PowerShares Emerging Market Sovereign Debt ETF (PCY) for the last nine months, which is invested primarily in the debt of Asian and Latin American government entities, and sports a generous 6.44% yield. This beats the daylights out of the one basis point you currently earn for cash, the 3.76% yield on 10 year Treasuries, and still exceeds the 4.70% 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 backs 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 by letter to practice her English). Moody’s has been rattling its saber about a downgrade of US debt on an almost daily basis, and it is just a matter of time before this once unimaginable event transpires. When it does, there could be a stampede into the debt of other healthier countries, potentially sending the price of PCY through the roof.

A price appreciation of 170% to $26.19 a share in the past year tells you this is not exactly an undiscovered concept. Since my intial recommendation, money has been puring into PCY, taking it up to a record $500 million in assets. Still, it is something to keep on your “buy on dips” list.

I lived through the Latin American debt crisis of the seventies. You know, the one that almost took Citibank down? Never in my wildest, Jack Daniels 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? But that day is coming.

To see the data, charts, and graphs that support this research piece, as well as more iconoclastic and out of consensus analysis, please visit me at www.madhedgefundtrader.com . There you will find the conventional wisdom  mercilessly flailed and tortured daily, and my last two years of research reports available for free. You can also listen to me on Hedge Fund Radio by clicking on the “Today’s Radio Show” menu tab on the left on my home page.

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Gwynplaine's picture
Gwynplaine (not verified) Mar 26, 2010 12:27 PM

For the short term, the PCY might make sense.  Longer term, I'm not so sure.  If some of the major developed economies end up defaulting over the next several years, it will be a signal to (better credit risk) debtors around the world to shrug their responsibilities.   Suppose that the UK, US, and Japan get creditors to settle for partial payment or reduced payments over time.  This will make explicit the attitude that debts do not have to be repaid in full. 

It may be a change in world moral values that makes long term debt a more risky proposition than equity.  That lesson will not be lost on the BRIC countries.

trav7777's picture

Yeah, lemme hide out in the sovereign issues of bankrupt states...FANTASTIC IDEA.

I mean, it's not as if the recent auctions have been weak and bond funds haven't been falling too, right?

jbar's picture

Moody's is the government. Good luck waiting on a downgrade.

Gordon_Gekko's picture

You gatta be kidding me.