Bond Wars Update: International and Junk 16 comments
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There are two areas of bond investing that have seen large inflows this year: international bonds and domestic high yield, otherwise known as junk.
The table below displays the results for the international ETFs available in 2008:
Assets Under Management of International Bond ETFs in Millions
click to enlarge
The data in the table above have interesting implications. First, SSgA has its first fixed income success against its arch-rival, Barclays. Note the total international assets under management for WIP and BWX as compared with iShares’ EMB. Although these are not comparable funds in all respects, each of the three are international in scope; clearly SSgA had the better idea. Looking ahead, perhaps as early as the end of this year, Barclays is taking steps to remedy this disparity by bringing out several high quality international offerings.
The second implication is that international bonds of all qualities have achieved critical mass. The two international funds shown above total $1,113 million, which is half a billion more than their investment grade domestic offerings, BIL (ultra short duration), IPE [TIPS], ITE (intermediate bond), TLO (long-term bond) and LAG (Lehman Aggregate). It’s a similar story for PowerShares, whose two high quality domestic bond funds total less than $50 million in assets, while its relatively new EM debt fund has over $121 million. 2008 has been the year of international debt.
It’s a similar story for domestic high yield. In the table below, three junk offerings are shown.
Assets Under Management in Junk Bonds ETFs in Millions: April 9, 2009
For fixed income products, these are good numbers, except for PowerShares. They have not gained traction with their junk collection.
The chart below shows the YTD performance of each of the three ETFs:
YTD Price Performance of High Yield Bond ETFs
All three show a similar trajectory, which is the normal path of junk bonds in a declining economy. These types of financial instruments are quite sensitive to economic conditions: in good times they do well, and the spread narrows between them and investment grade instruments; the spread widens in hard times because more defaults are expected.
There is a common thread that unites the success that domestic high yield and international bonds have had this year-- low interest rates in America. For an American investor, there are no domestic fixed income products that keep up with inflation other than Treasury Inflation Protected Bonds. Prices of fixed income assets here have languished in the face of climbing inflation and the complete inability of the Federal Reserve Open Market Committee to do anything about it. American bond prices are showing the effects of the conflict between expectations for higher interest rates and the persistence of low interest rates in a flagging economy.
The YTD price history of IShares’ AGG, which follows the Lehman Brothers Aggregate Bond Index, shows this conflict. The Lehman Brothers index is widely representative of the American investment grade bond market. It includes corporate bonds, as well as Treasury and mortgage based bonds, and maintains an intermediate average duration.
The chart below shows the YTD prices of AGG (in black), combined with the prices of an international bond index, BWX( in red) and the price points of UUP (in yellow), the PowerShares dollar bullish ETF. Reasons for including these three seemingly disparate investment instruments becomes clear when they are shown over the same time period.
First, note that AGG has roughly held its own during the year, although with the course of interest rates for 2008 being slightly down, one would have expected AGG to rise slightly. But, this has not been a normal year. Expectations for interest rates have been persistently up because of the outlook on inflation. However, interest rates have remained exceptionally low, because our economy has been so weak that raising rates would make worse what is already bad. We are left with stagflation, which is the worst of both worlds. This is a condition that does not occur frequently in developed economies.
2008 Prices of ETFs: AGG, BWX and UUP
Now, focus on the red and yellow lines. Note how these two lines are almost mirrors of each other. When the dollar was falling, as it did from early February to mid March, BWX rose in price—A clear demonstration of the currency effect. And, when the dollar bottomed, and held its own from mid March to mid July, BWX fell. This comparison shows with more force than any amount of words, the role currency prices play in determining American prices of international fixed income holdings. It also shows how quickly international bond gains can be reversed when the dollar swings to the upside.
The next chart show AGG and BWX as total returns, where dividends are reinvested. Note both have risen: dividends do make a difference. But the recent fall in BWX has more than offset the dividend payments since early March. The U.S. index, AGG, however, has shown a more consistent gain over the 1-Year period. Although not denominated in a foreign currency, it is still affected by the dollar relative to other currencies.
1-Yr Total Returns of BWX (black) and AGG (red)
The biggest impediment to the continued growth of international bonds is the recent recovery of the U.S. dollar. The implications of this are not good for holders of long positions in any asset that is denominated in a foreign currency. Even if a foreign bond is paying an attractive rate of interest, which many are, a fall of their currency with respect to the dollar will eat up their higher interest payments. The last seven years of a falling dollar has led some American investors to believe it would continue indefinitely. Wrong assumption!
It might be wrong, however, to assume that all currencies will fall against the dollar. Some countries, such as China, Japan, Hong Kong, South Africa and Brazil, have large reserves on hand to mount a defense against a rising dollar. They may or may not do this, but each of them can if they want to.
My guess is that China’s yuan will continue rising against the dollar—they promised to revalue the yuan some time ago, and it needs to be done to help create a more balanced world economy. South Africa will probably keep roughly at par, unless they get into a prolonged balance of payments deficit. Hong Kong has followed a peg to the dollar for many years—so they will probably continue. Many experts expect a rise in the Japanese yen; it is becoming the flight-to-quality currency of the world’s markets. Brazil needs to let the real drop further in order to combat internal inflation, but I wouldn’t expect it to continue dropping for a long time. Mexico has a history of following the dollar, and they may continue along this path. They have a good reserve balance, but they also have some internal economic problems that need addressing. None of these are predictions: I’m guessing, and all my guesses may turn out wrong.
The bottom line on international bonds is firmly in the hands of the currency market. If the dollar continues its rise, there will be a continuing exodus of American money out of these assets. An alert ETF provider will give their existing investors options of where to put the money that a falling dollar liberates.
There are a few other new entrants into bond ETFs: Claymore, Bear Sterns, Wisdom Tree, Pro Shares, and PowerShares have domestic bond ETFs that have not been covered. All of these can be disposed of quickly.
Claymore brought out two bond ETFs (UBD and ULQ) in February of this year. Both have languished for market acceptance. UBD is their version of a Lehman Aggregate Bond Index, except it is a subset of their total market index, an oddball index that supposedly covers all fixed income products and all equities shares in America. UBD is a breakout of the bond portion of that index, but it is quite similar to the Lehman Aggregate in its characteristics. This fund began its life with about $5 million in initial assets in February, and as of April 9, it held $4.9 Million.
ULQ is an ultra short bond fund, using the old definition of ultra, meaning extra short in duration, not being shorted in the futures market. It, too, has not done well, having notched a $4000 gain in assets this year to date.
The Bear Sterns fund, YYY, was declared dead in their press release of 9/9/08. A fifty million dollar bet that didn’t pay off, it was an ultra short, actively managed fund that never quite got its sea legs.
WisdomTree recently introduced their ultra short fund, USY, and it has not fared any better than the others. It began with a $20 million stake and has stayed there for the first three months of its existence. They positioned this bond fund as part of the currency holdings (it does hold U.S. dollars), but it doesn’t look good in terms of market acceptance. There are already some well established ultra short bond ETFs in the market (SSgA’s BIL and iShares’ SHV), and they have done well. But no one else has, of yet.
ProShares has two domestic bond fund ETFs, both ultrashort (new definition, meaning they sell them short). PST shorts the Lehman 1-7 year Treasury Bond index, and TBT shorts the Lehman 20+ Treasury Bond Index. The tendency in the U.S. to expect rising interest rates is captured in these two offerings. If interest rates do, in fact, start going up, then the prices of longer-term bonds will fall. This is the bet you make with either of these instruments. Of course, the 20+ will fall much more than the 1-7 year Ts, assuming the rates rise the same for both maturities. PST already has $84 million in assets, and TBT has $283 million. It goes to show that the right product at the right time has a good chance of doing well. ProShares has struck a resonating note with these funds. They will probably crash if we ever reach a turning point where interest rates are expected to fall. But, by that time, ProShares will probably have an ultra long fund to sop up the assets fleeing the short side.
My original plan was to also cover upcoming bond ETFs that could be brought to market by the end of the year. But, this task has just become much more interesting. To do the new prospects justice, I am going to hold off until next time, when I can give them adequate attention. Until then, keep your eyes out for eight ways to commit financial suicide!
Disclosure: Long AGG and UUP.
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This article has 16 comments:
Best wishes,
Ray
You are correct about EMB. This fund does buy only U.S. dollar denominated debt. My apologize for my error in my first response.
Thank you for the information.
Ray
Any links or info would be appreciated.
Thank you
Then, they have over 4.5% invested in Russian bonds. Russia's equity market has been forced to close for the last two days, attributable to the meltdown of some of their largest banks--all are severely undercapitalized (like the U.S. banks, only more so), and the ruble has been vanquished.
I have no time table for when any of these collapses will conclude. At the edges of the financial world, all these countries, indeed almost all emerging markets except China and India are suffering greatly as the world's investors try and get a grip of what's happening. I don't think there is going to be any fast recovery for them. But, when they do recover, it will be twice or three times the rate of developed economies. The volatility of emerging markets equities, currenies and debt is exceptional. You must be prepared to take some big lumps if you get into these investments. Personally, I have confidence that most of those I listed will recover. Their economies have far to go on the upside. But their fairy tale growth has ended for now, and it may be some months before all the commotion settles down.
For now, there is an international flight to quality--can you believe U.S. Treasuries? They are still the prime debt instruments in the world.
Best wishes,
Ray
Ray
^PCY-NV 23.26
^PCY-IV 22.95
PCY 20.20
On Sep 18 01:03 PM rayhendon wrote:
> Looking at the detail of their holdings, it looks like the death
> list of an airlines crash where there no survivors. Chilean debt
> is their largest holding, and the Chilean economy and currency has
> been besieged lately. This is also true for most of Latin America.
> Then they have Bulgaria, Hungary and Turkey--two of which (Hungary
> and Turkey) have currencies under severe attack. I don't have good
> data on Bulgaria, but it is a former vassal state of Russia, with
> little experience in modern capitalism.
>
> Then, they have over 4.5% invested in Russian bonds. Russia's equity
> market has been forced to close for the last two days, attributable
> to the meltdown of some of their largest banks--all are severely
> undercapitalized (like the U.S. banks, only more so), and the ruble
> has been vanquished.
> I have no time table for when any of these collapses will conclude.
> At the edges of the financial world, all these countries, indeed
> almost all emerging markets except China and India are suffering
> greatly as the world's investors try and get a grip of what's happening.
> I don't think there is going to be any fast recovery for them. But,
> when they do recover, it will be twice or three times the rate of
> developed economies. The volatility of emerging markets equities,
> currenies and debt is exceptional. You must be prepared to take some
> big lumps if you get into these investments. Personally, I have confidence
> that most of those I listed will recover. Their economies have far
> to go on the upside. But their fairy tale growth has ended for now,
> and it may be some months before all the commotion settles down.
>
> For now, there is an international flight to quality--can you believe
> U.S. Treasuries? They are still the prime debt instruments in the
> world.
>
> Best wishes,
>
> Ray
> Ray
Also, with regard to trading below NAV, I suspect that since the Russian exchanges have been unable to trade for a few days, there is no reliable way to evaluate their debt obligations. When trading opens again, which I am sure it will, then we will get a better understanding of the value of the ruble and the value of their securities. Until then, the market apparently holds a dim view of their real value.
However, I am bullish on emerging markets over the long haul. Russia and Turkey have a lot of room to grow, but it's going to be bumpy. My concern in Russia is the fate of the ruble. It is mostly a free floating currency, as far as I know. It could take a huge hit if the political situation there gets much worse.
Good luck.
On Oct 11 01:55 PM cma wrote:
> Are there any ultra-long bond ETFs?