This week we take a look at short, very high quality A2/A rated bonds from Caterpillar Inc.(CAT) denominated in Russian rubles, which are currently trading at about a 5.50% yield to maturity in December of 2015.
Corporate bond linked to the Russian Ruble
Caterpillar International has Russian ruble bonds, with a coupon of 7.5%, which are trading at a slight premium and indicating a yield to maturity of about 5.5%. This is a noticeably lower yield than some of the bonds we have selected in the recent past. However, considering its short 32 month maturity, its high investment grade rating and its very distinguished brand name issuer, it is our opinion that it represents an excellent vehicle for currency diversification away from the typically overweighted U.S. dollar fixed income portfolio. Furthermore, it offers a very favorable yield relative to the incredibly low yields that more common high quality investment grade corporate bonds are currently yielding in U.S. dollars.
We believe the dollar's longer term weakening trend against many world currencies remains a major concern for investors seeking protection against its devaluation and a further erosion of its buying power. Although Japan's central bank willingness to pursue quantitative easing has recently strengthened numerous other major currencies, including both the Euro and the U.S. dollars, we view the recent European debt concerns to have unduly weakened the Russian Ruble. Therefore, we see this as an opportune time to increase our exposure to the ruble and the Russian economy, which appears to continue to show relatively good growth potential in spite of the Europe's ongoing financial turmoil.
Russia has undergone significant changes since the collapse of the Soviet Union, moving from a globally-isolated, centrally-planned economy to a more market-based and globally-integrated economy. Economic reforms in the 1990s privatized most industries, with notable exceptions in the energy and defense-related sectors. Russia is the largest country in the world and the fifth largest economy. The Russian economy is commodity driven. Russia is the world's largest producer of oil (12 percent of world output), natural gas (18 percent) and nickel (20 percent). The energy sector is the most important; it contributes 20-25 percent of GDP, 65 percent of total exports and 30 percent of government budget revenue. The Russian export industry consists primarily of natural gas to the eurozone, is the world's second largest exporter of oil, and is the third largest exporter of steel and primary aluminum. This reliance on commodity exports makes Russia vulnerable to boom and bust cycles following the highly volatile swings in global commodity prices, and provides reason for the higher correlation of its currency to oil prices.
The economy had averaged 7% growth since the 1998 Russian financial crisis, resulting in a doubling of real disposable incomes and the emergence of a middle class. The Russian economy, however, was one of the hardest hit by the 2008-09 global economic crisis as oil prices plummeted and the foreign credits that Russian banks and firms relied on dried up. The economic decline bottomed out in mid-2009 and the economy began to grow in the first quarter of 2010. The GDP in Russia expanded 1.8% in the fourth quarter of 2012 over the previous quarter, and has averaged about 3.7% annually over the last two years.
Russia's competitive flat income tax rate and low corporate tax rates support innovation, although private enterprises also must cope with "informal taxes" such as bureaucratic hassling and corruption. Other taxes include a value-added tax (VAT) and a regional property tax. In the most recent year, Russia recorded a budget deficit equal to 0.02 percent of the country's GDP, and the its debt to GDP was last reported by the International Money Fund at 9.6%. The state maintains a strong presence in such key sectors as energy and mining, and the unemployment rate in Russia decreased to 5.80% in February 2013, while inflation was recorded at 7.3%. As a means of comparison, over the last 12 months the yields on ten year Russian government bonds have declined 1.18 percent and currently stand at about 6.8%.
About Caterpillar Inc.
As the world's leading manufacturer of construction and mining equipment, diesel and natural gas engines, industrial gas turbines and diesel-electric locomotives, Caterpillar needs little, if any introduction, to most investors. The Cat equipment product line, consisting of more than 300 machines, sets the standard for the heavy equipment industry. A global leader in size, scope, reach and character, Caterpillar Inc. is a genuine enabler of sustainable world progress and opportunity, defined by the brand attributes of global leadership, innovation and sustainability.
Owing to reduced global demand for mining equipment and to bring production in line with demand, Caterpillar recently announced plans to lay off more than 400 employees, or about 11% of its workforce at its Decatur, IL factory. Amid the growing concerns of the sluggish pace of global economic recovery, Caterpillar temporarily retrenched employees last October and shut down parts of its Decatur facility for a week in November and entire month of December due to the fall in demand. However, this time the layoffs appear to be permanent. Caterpillar had previously added production capacity for many of its products. However, with the growing concerns and uncertainty about the pace of economic growth, short-term economic risks in the U.S, the Eurozone debt crisis, and the slowdown in China's growth, Caterpillar has now opted to be cautious toward acquisitions and expansion investments. Mining companies such as Vale S.A.(VALE) and BHP Billiton Limited (BHP) also have been revisiting and trimming their capital expenditures plans following the slowdown in economic expansion in China, the world's largest user of coal and metals. Prices for coal and iron ore have dropped due to slowing growth in China and European debt problems.
Caterpillar's results have borne the brunt of continued economic turmoil in Europe and its domino effect on the rest of the world. Furthermore, reduced sales, lower production and a decline in inventory primarily resulted in lower fourth quarter 2012 earnings for Caterpillar. While Caterpillar remains challenged with slowing demand and inventory corrections, for fiscal 2013, sales are expected to be in the range of $60 to $68 billion and earnings between $7.00 and $9.00. And although the equity markets may appear to have been less than kind to its shareholders over the last year, its Board of Directors voted this week to maintain the quarterly cash dividend of fifty-two cents ($0.52) per share of common stock in response to what they declared to be "a record year in 2012." Caterpillar's balance sheet is strong, and dividend payments are perceived as a good way to reward long-term investors in the company.
The total debt of CAT is 40.15 billion, or about 43.4% of its current enterprise value, and its operating cash flow is about 5.24 billion compared to interest expenses of 467 million. This Caterpillar bond is currently rated A2 by Moody's and A by Standard & Poor's.
The default risk is Caterpillar's ability to perform. Considering this bond's short term maturity and CAT's prestigious (and near monopolistic) position of strength within the industry, we don't see where the default risk of any bond could get much lower, and it is our opinion that the default risk is negligible relative to the currency risk of the Russian ruble.
The currency risk could and will affect the returns of these bonds and possibly in a negative way as it exposes investors to Russia's economy. This currency risk is somewhat mitigated by a higher yield than what is currently available in similar maturity bonds denominated in U.S. dollars from this same issuer.
Russia's long-term challenges include a shrinking workforce, a high level of corruption, difficulty in accessing capital for smaller, non-energy companies, and poor infrastructure in need of large investments. The Russian economic decline bottomed out in mid-2009 and overall has fared relatively well to other major world economies. Higher oil prices, which has buoyed much or Russian recent growth, could help Russia reduce the budget deficit inherited from the lean years of 2008-09.
Accessibility and Liquidity
Caterpillar has numerous outstanding US dollar denominated bonds with varying maturities. However, we have specifically targeted this debt denominated in Russian ruble for the purpose of diversification away from the US dollar, as we believe having a portion of fixed income revenues outside of the dollar actually helps lower the overall portfolio risk to the greenback's potential devaluation against other global currencies. We also believe that acquiring and owning individual maturity definite bonds offer significant advantages over owning various emerging market funds and ETFs that blend together various winners and losers into a mixed yield cocktail. Achieving an institutional sized yield typically requires an institutional sized bond purchase, and even though broker/dealers may require an institutional sized bond purchase, it is possible with an advisor or an investment manger's assistance for a number of retail clients to be combined together in order to make a larger institutional sized purchase. This is how we have been able to facilitate purchases as low as US $5,000 for many retail buyers.
While acknowledging that every investment vehicle involves varying elements of risk, we believe that the recent strengthening of the US dollar relative to the Russian ruble represents an extremely attractive opportunity for initiating a moderately longer term exposure to the Russian economy with a very high grade issuer, at a reasonably attractive short term yield. A continued demand for Russia's abundant supply of oil and natural gas is likely to result in a continued strengthening and expansion of their economy, which in turn is likely to result in the strengthening of the ruble currency, which we believe is one of the currencies more highly correlated to the price of oil. Therefore, we view the ruble currency risk of this prominent emerging market as an unusual and significant opportunity that we have highly recommended our clients take in their continued effort to diversify away from overweighted US dollar based assets, and it is why we are adding these CAT Russian ruble bonds to our Foreign and World Fixed Income holdings.
Issuer: Caterpillar Inc.
Yield to Maturity: ~5.66%
Disclosure: Durig Capital clients may currently have positions in these CAT 2015 bonds.
Please note that all yield and price indications are shown from the time of our research. Our reports are never an offer to buy or sell any security. We are not a broker/dealer, and reports are intended for distribution to our clients. As a result of our institutional association, we frequently obtain better yield/price executions for our clients than is initially indicated in our reports. We welcome inquiries from other advisors that may also be interested in our work and the possibilities of achieving higher yields for retail clients.