Simple investment grade corporate bonds are typically viewed as being more boring and perhaps much less "sexy" than other debt and equity instruments, which include a rapidly increasing number of complex and highly structured notes, funds, or indexes. However, our dawning recognition of such great value in Bank of America's (BAC) Brazil bond appears to bring with it an exception to such humble honors.
In short, this is the richest yield we have found to date as a result of the recent plethora of "bad press" that Bank of America has endured. While the mood (and direction) of the markets is likely to remain unstable and as unpredictable as its ever been, a confluence of recent news inclines us to think that "the bad" is probably already baked in and that maybe much of the good is simply missed, overlooked, or ignored. This is when and how achieving above-average returns take root, and in reality, may be much easier to attain than the average retail investor realizes. What is necessary, however, is for an investor to have the savvy, the right information, the right connections, and the willingness to "go against the grain" if necessary. Of course, that’s also when and how a very good investment advisor can prove his or her worth, and it is why we here at Durig Capital provide the following perspective for your consideration.
Corporate Bond linked to the Brazilian Real
Bank of America has issued debt, denominated in the Brazilian real, which currently has a yield of about 12.5% for 37 months. The recent decline in this bond's price (and its increase in yield) appears to be a possible result of increased negative sentiment and much highly publicized criticism against a floundering global financial system, of which Bank of America is a very large and easily identifiable target. The incredibly high yield and short maturity of this Brazil bond, when considered with its solid “A” rating and positioning as one of the “too big to fail” icons within the US financial system, offers what we see as an extremely favorable reward to a relatively low risk position.
The decline in the strength of the Brazilian real relative to the US dollar (which appears to primarily be a result of greater concerns over the future of the euro) also offers an ideal opportunity for increasing our exposure to the Brazilian currency within a basket of foreign fixed income holdings, as we believe the dollar’s longer term weakening trend against many of the world currencies remains a major concern for investors seeking protection against its devaluation and a continued erosion of its buying power. In our ongoing effort to address the concerns of our clients in protecting their existing wealth from the destruction caused by the persistent devaluation of the dollar, we believe this Bank of America Brazil bond represents this week’s best opportunity to add the higher yields of one the world’s best emerging economies to our Foreign and World Fixed Income holdings at a quite favorable exchange rate.
Wealth Preservation Concerns
Wealth preservation continues to be the name of the game in the West. In other words, the focus for many people is not to make more money, but to preserve the wealth they already have. Declining equity and property prices, ultra-low interest rates, minimal pay raises, elevated inflation, ineffective politicians, potentially increased taxes, and the constant printing of more money are converging into what appear to be perfect financial storm conditions, where one financial storm after another beats down, eroding away wealth, until the aforementioned conditions finally change. We see little change on the horizon for the continued borrowing from tomorrow as means to pay for the lifestyle of today. With US Ten Year treasury yields not much above 2% and inflation rates undaunted, a certain degree of wealth destruction looms on the horizon, even while these T-bills are regarded as being “safe.”
Recently, the Wall Street Journal reported, “the Congressional Budget Office said it anticipates that the trade-weighted exchange value of the U.S. dollar will decline at a moderate pace over the next 10 years.” And, in a further clarification of what it is seeing, it was reported that “So far this year, the dollar has dropped sharply even through the European debt crisis continues to unsettle international financial markets. That fall has prompted questions about whether the status of the dollar as a reserve currency and a safe haven in times of economic crisis has diminished because of investors’ concerns about rising U.S. government debt.”
We have undertaken the effort to protect our client’s assets against the persistent destruction associated with an ever increasing supply of US dollars by scouring the globe in search of sound investments in a basket of the strongest global currencies, and it is why we have chosen Bank of America’s very high yield, short term Brazil bond as This Week’s Best Bond.
By far the largest and most populous country in South America, Brazil continues to pursue industrial and agricultural growth and development of its interior. Exploiting vast natural resources and a large labor pool, it has large and well-developed agricultural, mining, manufacturing, and service sectors. It is the world's largest producer of coffee, sugar and orange juice and the second-largest exporter of iron-ore and soybeans. Brazil’s offshore oil fields have turned it into a net crude exporter, helping it expand its presence in world markets, and its economy outweighs that of all other South American countries.
Brazil's economy slowed sharply in the second quarter, but domestic demand has remained resilient as consumers have been able to maintain their buying power despite the impact of higher interest rates and stiffer credit terms. That's because Brazil's unemployment rate is at record lows, with the tight labor market forcing companies to pay more to attract and keep a burgeoning work force. Despite concern about the impact of slower Chinese growth, Brazil, the world's eighth-largest economy, is expected to grow more than 4 percent this year (see trade flow chart below.) This robust economic growth underscores the importance of emerging markets as the developed world struggles with a sluggish rebound from the global economic slowdown.
The inflation rate in Brazil was last reported at 7.23 for August, the highest since June 2005 and well above the ceiling of the government’s official year-end target of around 4.5%. Despite continued price pressures in Latin America's largest economy, the Brazilian Central Bank shifted course at its meeting last week to cut interest rates because of concerns about global economic growth. While many economists share the government's belief that inflation will eventually trend back toward the 4.5% target, the rate cut could prolong the time for that to happen.
Stanford University has rated the Brazilian economy number #10 on its global Sovereign Fiscal Responsibility Index, a placement significantly above #28 ranked (out of 34) United States.
About Bank of America
Bank of America continued to support the U.S. economic recovery by extending approximately $147 billion in credit to consumers, small businesses, large companies and others during the second quarter of 2011, approximately $3 billion more than the previous quarter. In fact, Bank of America serves one out of every two U.S. households with checking, savings, credit and/or home loans, and is one of the world’s largest financial institutions.
This week, Bank of America reported net income of $ 6.2 billion for the third quarter, compared with a net loss of $ 7.3 billion in the year-ago period (although a number of significant items affected these results.) Revenue, net of interest expense, on a fully taxable equivalent (FTE) basis rose 6 percent to $ 28.7 billion. In more general terms, Chief Executive Officer Brian Moynihan said “This quarter’s results reflect several actions we took that highlight our ongoing transformation toward becoming a leaner, more focused company” and Chief Financial Officer Bruce Thompson spoke of a focus for the quarter on strengthening the balance sheet by selling non-core assets and building capital to position the company for future growth.
Bank of America has indeed continued to strengthen the balance sheet, reducing its size by $42 billion from last quarter and increasing the common equity ratio to 9.50 percent. Short-term debt was reduced by $17 billion and long-term debt by $28 billion during the third quarter. Risk-weighted assets were also reduced by $33 billion.
|3 Year Bonds||Yield||Country Fiscal Ratings||Currency||Ratings|
|US Treasury||00.47%||28 of 34||US Dollar||AA+,AAA,AAA|
|Bank of America||12.50%||10 of 34||Brazil Real||A,Baa1, A+|
This is a yield pickup of over 12% when compared with corresponding US Treasuries, which gives this Bank America Brazil bond a very solid double digit positive accrual rate. Even if the Congressional Budget office is wrong and we have strong appreciation in the dollar, as long as the currency appreciation averages less than 12% annually relative to the real this bond would still outperform the 3-year US Benchmark bond. However, if the CBO is correct, and should the US currency decline instead of gain, any appreciation of the real would be accretive and add on top of the already astounding 12% annual return.
Please compare Brazilian Linked Bank of American Bonds to Australian Bank of American bond of shorter maturity.
The default risk is Bank of America’s ability to perform. Given Bank of America’s improving performance, it is our opinion that the default risk for this short-term bond is very minimal relative to the currency risk of the Brazilian real.
The currency risk of the Brazilian real could and will affect the returns of these bonds and possibly in a negative way as it exposes investors to the Brazilian economy.
Accessibility and Liquidity
Bank of America currently maintains about $800 billion of outstanding debt, mainly denominated in US dollars. Aside from owning various emerging market funds and ETFs that blend together various winners and losers into a mixed yield cocktail, the question arises as to how a retail investor might own or acquire individual Bank of America’s Australian denominated bonds. Many times broker/dealers require an institutional-sized single bond purchase. However, it is also possible for a number of smaller retail clients to be combined together in order to make a larger institutional sized purchase. Previously, we have been able to facilitate purchases as low as $5,000 US Dollars.
We hope NOT to see any further destruction of wealth resulting from a constant decline in the US dollar relative other global currencies as forecast by the Congressional Budget Office, and we acknowledge that a strengthening of the US dollar would directly reduce the total returns of this Brazilian real denominated bond. On the other hand, should the US dollar continue on the long-term path of devaluation that it has been on, this alone could add quite significantly to the already highly positive accruing returns of this bond, not to mention the possible stellar returns that would result should the US dollar ever lose its domineering status as the world’s reserve currency and collapse against a basket of other stronger currencies.
Considering Brazil’s prominent position as a leading emerging market economy, stable political system, and solid growth prospects in spite of broader global slowdowns, we view this potential gain of a remarkably high-yield offering an intelligent risk to reward investment, and as some protection against a further loss of wealth with a continuation of the US dollar’s weakness against the real. Therefore, we are using this opportunity to diversify away from heavily overweighted US dollar based assets and into one of the world’s top emerging markets, and are adding it at this time to our Foreign and World Fixed Income holdings.
Disclosure: I am long BAC.