Looking for higher yields? This week, we look at short 44 month Republic of Cyprus Government Bonds (denominated in Euros) that are yielding about 14%. In spite of the island's moves to reduce its deficit and improve its finances, the country was caught up in Standard & Poor's downgrade last month of nine eurozone countries. While the S&P ratings change moved it from investment grade to BB+, Fitch's reassessment left the rating one notch above junk status at BBB-. Knowing that rating agencies don't always "get it right," we decided to take a closer look at the economy of Cyprus and determine for ourselves whether the very high yields indicated by these heavily discounted notes would meet our own stringent criteria for "an intelligent risk," where the potential return far outweighs its discernible risk. As a result of this effort, as explained in more detail below, we see these short term Cyprus sovereign bonds, denominated in Euros, as a very savvy opportunity to gain a well compensated exposure to both the Euro, and to the economy of Cyprus, and gladly add them to our Foreign and World Fixed Income holdings.
Wealth Preservation and U.S. Dollar Concerns
Global equity and commodity markets appear to started the year on a positive note, yet wealth preservation and the returning weakness of the dollar remain a top priority for many people. Property prices that remain depressed, ultra-low interest rates that are set to be in place for several more years, proposals that are sowing seeds for significantly increased taxes, and a Fed that appears to be hell-bent on its multifarious control and money printing efforts to backstop numerous world economies, all continue to paint an unsightly visage of broad and rampant wealth destruction for high (and perhaps even low) net worth individuals.
Given the sad state of the current European debt crisis and economic forecast, the obvious disdain and broad negativity that many popular financial pundits have towards the outlook and uncertain future of euro, and the Fed's stated proclivity to support the European financial system and the Euro with its U.S. dollar creative ability, we think the merits of holding a few European Central Bank Notes (potentially netting over 14% annually while loaned to the Republic of Cyprus for 3 ¾ years) would go a long ways towards easing the pain or disappointment some might feel in holding longer five year U.S. Treasuries (^FVX) that yield a mere 0.88%, or in not being able to magically (or legally) produce or grow their own virtual money.
Flooding the banking system with cheap (fiat) money is, of course, the central bank's traditional "fix" to any looming credit crunch. If the ECB can't or doesn't provide enough liquidity to the European financial system with cheap euros, there's always the Fed to turn to. Therefore, the financial system itself is poised to survive, and thereby the global economy survives. If or as any one bank (private, public, or national) or group of banks fail, the failure can and will be contained by larger banks or groups of banks, and the financial system and its fiat currencies, in spite of relentless devaluations, live on.
We have undertaken the effort to protect our client's assets against the persistent erosion of wealth resulting from inflation rates that remain significantly higher than the extremely low, but "safe," yields currently available with banksters and in U.S. Treasuries. By scouring the globe in search of sound investments, in the strongest global economies, we strive to offer the best possible high yield instruments that we think offers both a high income stream and the possibility of positively accruing money in spite of broad economic uncertainties, and it is why we have chosen this relatively short term Republic of Cyprus Government Bond, denominated in euros, as This Week's Best Bond.
Economic Background of Cyprus
The area of the Republic of Cyprus under government control has a free market economy dominated by the service sector, which accounts for nearly four-fifths of GDP. Tourism, financial services, and real estate are the most important sectors. Erratic growth rates over the past decade reflect the economy's reliance on tourism, the profitability of which often fluctuates with political instability in the region and economic conditions in Western Europe. Nevertheless, the economy in the area under government control has grown at a rate well above the EU average since 2000. Cyprus joined the European Exchange Rate Mechanism (ERM2) in May 2005 and adopted the euro as its national currency on 1 January 2008. An aggressive austerity program in the preceding years, aimed at paving the way for the euro, helped turn a fiscal deficit (6.3% in 2003) into a surplus of 1.2% in 2008, and reduced inflation to 4.7%. This prosperity came under pressure in 2009, as construction and tourism slowed in the face of reduced foreign demand triggered by the ongoing global financial crisis.
Internationally, Cyprus promotes its geographical location as a "bridge" between East and West, along with its educated English-speaking population, moderate local costs, good airline connections, and telecommunications. The underdeveloped agrarian economy inherited from colonial rule has been transformed into a modern economy, with dynamic services, industrial and agricultural sectors and an advanced physical and social infrastructure. Among the most prosperous people in the Mediterranean region, the GDP per capita for Cyprus is about $30,000, and Cyprus is ranked 23rd in the world in terms of the Quality-of-life Index.
Although Cyprus lagged behind its EU peers in showing signs of stress from the global crisis, the economy tipped into recession in 2009, contracting by 1.7%, and has been slow to bounce back since, achieving only a 1.0% growth in 2010 and no economic growth in 2011. Serious Cypriot financial sector problems surfaced in early 2011 as the Greek fiscal crisis and eurozone debt crisis deepened. Two of Cyprus's biggest banks are among the largest holders of Greek bonds in Europe and have a substantial presence in Greece through bank branches and subsidiaries. A liquidity squeeze appears to be choking the financial sector and the Cypriot economy as a result of concerns over the European Union crisis. Cyprus's borrowing costs have risen because of its exposure to Greek debt, and their budget deficit rose upwards of 7% of GDP in 2011, a violation of the EU's budget deficit criteria.
Disturbed by S&P's credit rating downgrade last month, Finance Minister Kikis Kazamias claimed that the agency ignored the fact that the Republic of Cyprus is one of a few countries that has fully covered its financing requirements for 2012, and that the island has adopted several austerity packages to cut high government deficits. A budget passed by parliament in December projected a deficit of no more than 2.5 percent of GDP this year compared with about 6.0 percent in 2011, and it recently clinched a 2.5 billion euro ($3.2 billion) loan from Russia, which authorities say will cover its financing needs this year. Cyprus's two largest banks, Bank of Cyprus and Marfin Popular, are exposed to Greek sovereign debt and both submitted plans for recapitalization to the national regulator last month. Although it is likely that the banks will take a hit on Greek government bonds, it was announced that the banks would be able to recapitalize on their own and would not need state support. With one of the lowest tax rates out of the 25 EU member states and very good communications network, Cyprus has an incredibly attractive onshore/offshore center for business and banking purposes, and has a wide network representing over 40 different banks across the country.
Amid the continuing financial crisis and the weak growth of the Cypriot economy, projected at a mere 0.2% GDP in 2012, the government introduced a series of austerity measures that would enable Cyprus to meet its medium term commitments to the EU and particularly for a budget deficit of 2.8 GDP in 2012 and a zero deficit by 2014. On August 27, 2011, the Parliament approved the first fiscal consolidation package with a fiscal impact of 1% GDP or 180 million EUR, while a bill for the increase of VAT rate to 17% from 15%, which would yield an additional 140 million euro to the state coffers, is pending for approval. The Cabinet also approved a second fiscal consolidation package, incorporated in the 2012 state budget, which would reduce the budget deficit below the 3 per cent euro area benchmark (2.8%) in 2012. The package provides for the abolition of 939 vacant positions in the public sector, a 10% reduction of the starting salary of civil servants, the introduction of income criteria for the better targeting of welfare spending such as child allowance and student allowance (100 million EUR).
On November 18, 2011, the Finance Minister introduced a third fiscal consolidation package aiming at restoring Cyprus' credibility in the international markets. The package provides for the freezing of salary increases in the public sector (including COLA) for two years, with a yield of 355 million EUR, a scaled contribution of high earners in the private sector and the introduction of a 0.5% levy on the turnover of companies with local activities for two years. The austerity measures have been welcomed by the European Commission, which on January 11 ruled that Cyprus has taken effective measures to correct its excessive deficit.
Not to be overlooked, Cyprus has just launched a second licensing round for offshore exploratory drilling in hopes that new and recent discoveries will fire up the eurozone country's economy. An announcement on the Greek Cypriot Commerce Ministry's website Feb. 13 invited license applications for the following 90 days to search for mineral deposits in 12 of the 13 sections that together make up the island's 51,000-square-km exclusive economic zone off its southern coast. The announcement was first published Feb. 11 in the European Union's official journal. An initial licensing round in 2007 generated interest only from the U.S. company Noble Energy (NBL), which last year began exploratory drilling in Block 12, the southeastern-most section of the Greek Cypriot economic zone that sits close to a huge Israeli gas field. Officials are predicting more interest in the second round following Noble's discovery of an estimated 140 billion to 230 billion cubic meters of natural gas in Block 12, the section not up for licensing in this second round.
Τhe discovery of energy reserves in Cyprus' Exclusive Economic Zone is a promising feature that may be a big game changer for their economy, and Minister of Foreign Affairs Erato Kozakou Marcoullis was recently quoted as saying it "will have an historic impact on Cyprus." The scale of the findings by U.S. company "Noble Energy", she noted, is conservatively estimated at between 5-7 Tcf of natural gas, adding that these are the results from a single plot and from an initial search. "Cyprus has approximately 100 billion euros worth of natural gas recoverable from this single plot, that can satisfy the electricity production needs of the country for 210 years," she said. She also said that there are indications that it will be possible to move towards joint exploitation by neighboring countries, along with the launching of joint projects, across the line separating Exclusive Economic Zones, adding that the Republic of Cyprus is actively promoting this sort of cooperation as is the case with Israel and Egypt.
The most obvious risk is that of default. While the economy has rebounded from the 2009 recession, the recovery has been difficult due in part to its reliance on tourism and the governmental initial response of merely initiating or raising tax revenues in efforts to reduce the deficit shortfall. However, it appears they are now back on track with a more suitable austerity program aimed at directly reducing governmental costs. Adding in a consideration of the recent discoveries of significant energy reserves by Noble Energy and the monetary infusion any larger development of it would bring leads U.S. to believe that the greater risk may actually be the currency risk of the euro.
The currency risk is that of the euro, as it carries an exposure to the entire eurozone economy and the monetary policies of the European Central Bank.
Although the British colonial history of Cyprus has left Cypriots with a good level of English, it is no longer an official language in either the (Greek) Republic of Cyprus or the (Turkish) Republic of Northern Cyprus. Ongoing tensions with Turkey have not only consistently prevented a reunification of north (Turkish) and south (Greek) sides of the island, but have occasionally resulted in skirmishes. Consequently, there is geopolitical risk. While there is speculation that the recent discovery of natural gas in the maritime areas controlled by Greek Cypriots in the Eastern Mediterranean may open the way for co-operation between all parties, and may serve to eventually unify the island, there are no plain or clear indications to support that supposition.
With so many uncertainties lingering in the U.S. and global equity markets, we believe a high yielding fixed income portfolio that includes diversification in investment instruments (paying either dividends and interest), and in debt issuers (both corporate and sovereign), and in global currencies (both domestic and foreign) might not only spew a high income stream, but it might also lessen one's overall portfolio risk by protecting principle through a much broader diversification than is typically offered to most retail investors.
Overall, we view the higher risk vs. the very high reward of this short term bond as being very favorable for clients seeking a higher income while minimizing risk, and we think that these short term, very high yielding Republic of Cyprus Bonds, denominated in euros, will help diversify clients away from overly concentrated holdings in U.S. dollars. It is a poignant addition that will really spice up a well diversified fixed income portfolio, and it is why we are adding it to our Foreign and World Fixed Income holdings.
BB CUSIP: EI4492019
Price: € 71.90
Yield to Maturity: 14.03%
Disclosure: Some Durig Capital clients may already own a position in Cyprus government bonds. I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.