This week we look at two similarly rated (A-) investment grade Bank Bonds linked to the Brazilian Real, and their greater than 7% yields achieve the difficult task of providing higher fixed income returns with a short to medium term debt instrument in the currency of one of the world's strongest economies, Brazil.
Corporate Bonds linked to the Brazilian Real
Morgan Stanley (MS) and Merrill Lynch have issued bonds, linked to the Brazilian real, which currently indicate a yield to maturity of about 7.25 to 7.65% for about 4 ½ years. The high yields of these relatively short maturity bonds, when considered with their solid "A-" ratings and favorable positioning within the US financial system, offers an extremely favorable reward to relatively low risk position. As the European debt crisis continues to work its way through the long winter of uncertainties, it appears that the systemic risk to the financial system in Europe is easing. Consequently, the rising demand for high quality bank bonds has continued to push yields lower in global currencies across the board. The shock effect of the headlines that the sky is falling (the euro will fail), or that the coast is clear (the euro will survive), has evidently run its course and there is noticeably less push to be in or out of the euro. Along with less volatility in the FX currency markets, there also appears to be a resiliency of many currencies towards their longer term trend lines. While this bears a certain testimony to the effectiveness of quantitative easing and the proficiencies of a Fed seeking a weak dollar relative to other global currencies, it exacerbates the concern of many investors seeking protection against further devaluation of the dollar and the 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 this persistent currency devaluation, we believe these short to medium term Brazilian real linked Bank Bonds represent 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 reasonable exchange rate.
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. Currently, Brazil is the world's 11th largest oil producer.
Brazil's economy slowed sharply last year, but remained among the world's best at near 3%. Despite concern about the impact of slower Chinese growth, Brazil recently moved up to be the world's sixth-largest economy and was expected to continue growing about a little over 2 percent in 2012. After dropping to an annualized rate 1.6% earlier in the year, it appears to have rebounded and it is now expected to grow by 4 percent next year. This fundamentally solid economic growth underscores the importance of emerging markets, if it should even still be regarded as emerging, as the developed world continues to struggle with a sluggish rebound from the global economic slowdown and the European debt crisis.
Despite continued price pressures in Latin America's largest economy, the Brazilian Central Bank suddenly shifted course late last year to cut interest rates because of concerns about global economic growth. Given that the inflation rate in Brazil slowed to below 6% and is projected to pace closer to 5 ¼% for 2012, the rate cut appears warranted. The government's official inflation target remains around 4.5%. The inflation rate was recorded at 5.24% in August, a slight rise from its lows earlier this year. After announcing that the long-term reference rate for loans from the BNDES state development bank will be cut to a record low 5.5 percent from 6 percent, Finance Minister Guido Mantega stated earlier this year that Brazil's government plans to "maintain a devalued real" using various mechanisms to anchor the currency at a lower exchange rate that will help maintain competitiveness. Central bank President Alexandre Tombini has chopped its benchmark lending rate nine straight times to an all-time low of 7.50 percent, reducing the target lending rate by 5 percentage points since last August to shield the economy from the European debt crisis. By intervention in the market, the central bank put more dollars in the market to counter the weakening of its currency when it believed it was needed.
About Morgan Stanley
After the Glass-Steagall Act of 1933 which separated commercial banking from securities underwriting, Morgan Stanley opened for business after separating from JPMorgan (JPM). When the global financial crisis of 2008 brought down rivals Bears Sterns and Lehman Brothers, Morgan Stanley secured a $9 billion capital investment from Mitsubishi UFJ (MTU). The firm also helped the U.S. Treasury navigate the crisis at mortgage providers Fannie Mae and Freddie Mac. In 2009, James Gorman helped create the largest wealth management platform in the world when he led the merger and integration of Morgan Stanley's retail brokerage operations and Citibank's Smith Barney brokerage unit. The wealth management platform is a very good annuitized revenues, lower risk business. The Morgan Stanley Smith Barney joint venture is now a global leader with more than 18,000 financial advisors and $ 1.5 trillion in client assets.
Morgan Stanley delivered strong full year results, reporting fourth quarter net revenues at $5.7 billion and full year net revenues for 2011 at $32.4 billion. The Global Wealth Management Group delivered net revenues of $13.4 billion, with global fee-based asset flows of $42.5 billion and net new assets of $35.8 billion, the highest for both since the inception of the Morgan Stanley Smith Barney joint venture (MSSB). The year's pre-tax margin improved to 10% from 9% a year ago. Asset Management reported net revenues of $1.9 billion, with assets under management or supervision of $287 billion and positive net flows of $25.8 billion. Revenue improvements have continued into 2012, with both first and second quarters revenues for Morgan Stanley coming in at $6.93 billion and $6.95 billion.
About Merrill Lynch
Merrill Lynch & Co., Inc. is a wholly owned subsidiary of Bank of America Corporation (BAC). Following the combination with Merrill Lynch, one of the world's premier providers of wealth management, securities trading and sales, corporate finance and investment banking services, Bank of America became the largest brokerage in the world, with more than 15,000 Financial Advisors and approximately $2.2 trillion in client assets. Following the completion of Bank of America's acquisition of Merrill Lynch in November of 2010, ML & Co. became a subsidiary of Bank of America and established intercompany lending and borrowing arrangements to facilitate centralized liquidity management.
Net income for the Global Wealth and Investment Management segment of Bank of America rose 6 percent from the year-ago quarter to $543 million as lower revenue was more than offset by decreases in non-interest expense and lower provision for credit losses. Revenue declined 4 percent to $4.3 billion largely as a result of lower net interest income, primarily from the continued low rate environment and lower transactional activity. Assets under management (AUM) rose $21.2 billion to $682.2 billion from the year-ago quarter, driven by long-term AUM flows, while period-end loan balances were up $2.5 billion from the year-ago quarter to $105.4 billion. Net income for the six months ending June 30, 2012 was $1.09 billion. Bank of America's stated return on average economic capital (a non-GAAP financial measure believed to provide additional clarity in assessing the results of various business segments) for the Global Wealth and Investment Management segment was 31.81% for the first six months of 2012, ranking it a the top of Bank of America's various business segments.
~5 Year Bond Yields
|US Treasury||US Dollar|
|Morgan Stanley||US Dollar|
|Merrill Lynch||US Dollar|
|Morgan Stanley||Brazilian Real|
|Merrill Lynch||Brazilian Real|
These Brazilian Real Bank Bonds indicate a yield pickup of about 7% when compared to similar maturity US Treasuries, and a yield that is 4.5% greater than (or about 2½ times that of) similar bonds denominated in US dollars. Even if the Fed fails in its efforts to weaken the dollar, as long as the appreciation averages less than 4.5% annually relative to the Real, this bond would still outperform its US dollar counterpart. However, if the Fed is successful in weakening the dollar, and if it were to decline more than 4.5% annually, that much appreciation of the Real would indicate about a 12% annual return.
Please compare these Brazilian Real Bank Bonds to other Offshore Bank Bonds we have reviewed, such as Lloyd's Bank (LYG) Brazilian real bonds, Goldman Sachs (GS), or Royal Bank of Scotland Group (RBS) Australian dollar bonds of slightly shorter maturities.
The default risk is Morgan Stanley's and Merrill Lynch's ability to perform. Considering all of the improved fundamentals, improved balance sheets, strong credit ratings and the positive outlook for both Morgan Stanley and Merrill Lynch, it is our opinion that the default risk for this short term bond is 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
Morgan Stanley and Merrill Lynch have significant amounts of outstanding debt, mainly denominated in U.S. 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, maturity definite Brazilian real linked Banknotes. Many times broker/dealers require an institutional sized single bond purchase. However, with a broker and advisor's assistance, it is possible for a number of retail clients to be combined together in order to make a larger institutional sized purchase.
Even though it appears to be the intent of the Fed to weaken the dollar through further quantitative easing, we acknowledge that a strengthening of the US dollar relative to the Brazilian real 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 the leading emerging market economy, stable political system, and solid growth prospects in spite of broader global slowdowns, we view the gaining of about 2½ times the yield as a very compelling reason for choosing either of these Brazilian real linked bonds over their similar US dollar bonds. The combination of a remarkably high yield, a protection against the further loss of wealth that would result should the US dollar continue to weaken against the real, and a diversification away from heavily overweighted US dollar based assets into one of the world's top emerging markets is why we have chosen to add these approximately 4½ year bonds linked to the Brazilian Real to our Foreign and World Fixed Income holdings.
Issuer: Morgan Stanley
Rank: Senior Unsecured
Yield to Maturity: ~7.65%
Issuer: Merrill Lynch
Rank: Senior Unsecured
Yield to Maturity: ~7.25%
Disclosure: Some Durig Capital clients may currently own these 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.