So far in 2013, it hasn’t quite been the ‘Great Rotation’ (out of fixed income, and into equities) that we have been expecting. From where I sit, LATAM sovereigns and corporates remain largely overbought. But does that mean it’s far away? The S&P 500 has risen ~11% YTD, with little sign of weakening.

More recently, and perhaps more importantly, the expectations of an interest rate hike have become increasingly imminent. The Fed has spooked many investors and investment managers alike; although their rhetoric remains somewhat unclear:Bernanke; May 22, 2013:

“A premature tightening of monetary policy could lead interest rates to rise temporarily but would also carry a substantial risk of slowing or ending the economic recovery and causing inflation to fall further,” Bernanke said today in testimony to the Joint Economic Committee of Congress in Washington.

San Francisco Fed President John Williams; May 23, 2013:

“You could even imagine a scenario where we adjust it downward based on good data and then adjust it back, if the economy weakened”, he said. “We can adjust it down some, watch how things progress from there, and then adjust it again one way or the other.”

What can be said with some certainty is that we’ve experienced a prolonged bond bubble which can’t be sustained in perpetuity. With that in mind, here are a few ideas to hedge against rising rates.

1.   Floaters

This may be the simplest transition for the fixed-income minded investors out there. These reset at stated intervals, e.g. every 3 or 6 months. At the start of May 2013, there was talk of the U.S. Treasury issuing floating rate notes in the coming months to protect investors. “For now, the Treasury is considering monthly sales of $10 billion to $15 billion worth of floating-rate debt with a two-year maturity.” (Wall Street Journal)

2.   High- Grade US Bank Equities

Think Bank of America, Wells Fargo and Citigroup. Eventually, higher rates will increase the spread that the banks earn from lending compared to what they pay on deposits.

Bank of America (BAC) currently sits on $1.1 trillion of deposits against $900 billion in loans. Those deposits are an unbelievable “asset” to have going forward. According to BofA, a 1% increase in interest rates would positively affect its bottom line by $4 billion to $5 billion dollars.

(Real Money)

3.   Exchange Traded Funds (ETFs)

Example: Proshares Ultrashort 20+Year Treasury. This fund in particular seeks results that correspond to twice the inverse of the daily performance of the Barclays Capital US Treasury 20+ Year Treasury Bond Index. Essentially, as Treasury prices fall and rates rise this ETF should perform better. Of course, one should always consider the liquidity implications and strategies implemented for any type of fund. This is currently just over $4 above its 200-day moving average (considered a useful indicator – Forbes), most likely due to increased demand but may still have value in the event of a rate hike.

4.   Fixed For Floating Swap

Another way to benefit from rising rates would be an interest rate swap in which the counterparty pays a fixed rate on some notional principal, in exchange for receiving floating rate payments. Swaps, given their high liquidity are often viewed as a more accurate rate benchmark than Treasury curves.

This may be a lot to take in, but it is certainly worth the time to protect against a potentially rough summer. For more details, please feel free to contact us as we all want to prepare for the interest rate ‘when’ given that the ‘if’ seems to be answering itself already.

Please contact us at info@firstlinesecurities.com.

Gerard Stephens

Account Executive

Sales and Trading

EUROPE

Every summer it’s the same drill. After a strong start to the year, and an ‘okay’ spring, one thing or another happens in Europe and throws the market out of whack.

While the market transforms from a Rodney Dangerfield rally (it got no respect!) into an extremely resilient and increasingly confident move upwards, it seems like the most serious threats are primarily in Europe.

Here is a country by country overview of factors that could cause turbulence over the coming months. SPOILER ALERT: things don’t look good, and we can help you find ways to insulate your portfolio from any blow ups that may happen over the next 6 months.

FRANCE

Political factors continue to hold France back. President Francois Hollande has the lowest approval rating in France’s history for a president 12 months into their term. Additionally, there have been a number of corruption scandals which have impacted his administration’s credibility.

This is compounded by very heated rhetoric—such as taxing millionaires at 75%—that has led wealthier citizens to relocate to Belgium, Switzerland, and even Russia (in the case of noted actor Gerard Depardieu). The rhetoric has also led businesses to curtail production and there is widespread malaise in the business community; this was reflected in France’s recent dismal industrial production numbers.

Despite everything, we are unlikely to see any changes from the government, which almost guarantees continued economic decline.

PORTUGAL 

Portugal has earned some praise from observers and the market for enacting many austerity measures, and has shown some improvement in its credit metrics. Portuguese bonds were solid performers last year.

However, there has been some pushback from the citizenry on austerity, and pushback from the markets and the Germans on the pace and reach of reform. It is likely that Portugal will need a bailout extension, but the terms are likely to not be very generous, which will only compound the political backlash against austerity.

SPAIN

Spain faces a combination of political factors that mirror its position between Portugal and France. Like Portugal, it is facing backlash against austerity oriented policies.

Like France, they had elections and a rhetorically tough-speaking party came into power that has lost political capital and popularity through corruption scandals. The market also feels that reforms are not coming quickly enough, putting the government in a difficult position between choosing between the electorate and its ability to finance itself and fix its balance sheet.

ITALY

Italy faced a political crisis when there was no clear winner in their recent election, and the various factions found it difficult to assemble a ruling coalition due to stark policy differences.

This roiled markets not only in Europe and Italy, but as far afield as the U.S. and emerging markets. Italy is a major economy in Europe and not having a clear line of sight as to who would be running the country was a major cause for concern.

President Napolitano has agreed to serve another term at the head of a fragile government, in the interest of providing some stability, and designated Enrico Letta as prime minister. In his inaugural speech, Letta exclaimed that “Italy is dying from austerity alone. Growth policies cannot wait.” However, given the perennially fractious nature of Italian politics, it’s unclear whether Letta will gain enough momentum to enact those policies he so eloquently proposed.

GERMANY

Germany has increasingly focused inward as elections approach this autumn. Angela Merkel faces a veritable challenge as a new party, the Alternative for Germany (AfD) gains tractions and attracts defectors from all major parties. AfD is anti-euro and was formed last year by a group of leading German intellectuals from across the political spectrum.

Throughout the crisis, Germany has been recalcitrant and reactive, and has been the main pusher of the austerity snake oil on the continent. Germany continues to be haunted by the ghosts of hyperinflation from the 1920s and 1930s, when it took a barrel of Deutschmarks to buy a loaf of bread. That experience, plus the austerity the country had to go through in order to reintegrate East Germany into fray, informs much of their policy approach to the peripheral countries and their debt.

However, austerity has been discredited in both practice (none of the countries who undertook austerity are any better off than they were pre-crisis, and in fact most of them are worse) and theory (the results of one of the main papers arguing in favor of austerity was shown to be due to an Excel calculation error, among other mistakes).

It is unlikely that Germany will stray from its austerity mantra, and as the de facto economic power and policy settle within the European Union, they will continue to influence Europe in that direction.

CONCLUSION

Europe increasingly finds itself between a rock and an even harder rock. Austerity has been a disaster for most of the countries that adopted it, devastating the economies while turning the electorate into a restless and increasingly angry group.

The single currency prevents many countries from devaluing their monetary base to enable them to rebalance their economies and become more economically competitive.

The demographic picture is also unfavorable, as even with growth oriented policies many countries simply do not have the long term population growth to support their economies.

So what is the answer? That is beyond my pay grade but it is obvious that more needs to be done, maybe the combination of spending and easing, as per USA and now Japan, and not in the piece meal, reactive fashion at which it has worked in the past. In the mean time, we can expect Europe to be a main source of volatility, and whether you are in stocks or bonds or both, you should take steps to inoculate your portfolio against the risk that things get out of hand. 

Firstline has a number of options to help you not only protect yourself from benefit from uncertainty in Europe. Please contact us for more details at info@firstlinesecurities.com.

Michael J Cooper   
Trading / Investment Strategist
Firstline Securities Limited

‘Investment Grade or DIE!’ is the usual refrain from portfolio managers I speak with daily. Ok, maybe not said so drastically but the need for quality credits exists for mutual funds, pension funds, banks and other institutions alike.

Of course, the need for investment grade (IG) paper can be driven by a number of things, but usually boil down to mandate and/or board approval. So this treatise is directed at those of you who are looking to enhance yields with some of that excess cash; not already locked away for some statutory purpose.

This week we’d like to highlight a few “double-B credits” that may get your portfolios over the hump.

1. 

Sagicor 7.50% 05/12/2016

Industry: Financial Services

Country/ Region: Caribbean

S&P Rating: BB

Ask Price: 106.625

Ask Yield: 5.12%

Likes: hefty coupon, 3 yrs to maturity, 250+ bps pick-up over FCBTT 2016

Dislikes: Net Debt Exchange and Jamaica currency depreciation expected to hamper the profitability of SFC’s Jamaican operations, Barbados exposure. 

2.       

 JBS 6.25% 02/05/2023

Industry: Food & Beverage

Country/ Region: Brazil/ South America

S&P Rating: BB

Ask Price: 99.00

Ask Yield: 6.39%

Likes: world’s largest producer of animal protein, 470bps spread over 10yr US Treasury

Dislikes: last quarter JBS had a debt ratio of 3.7 times earnings, higher than the average 3 times for same-rated peers (Fitch).

3.  

Arcelor Mittal 9.85% 06/01/19

Industry: Metals & Mining

Country/ Region: Luxembourg/ Global

S&P Rating: BB+

Ask Price: 126.25

Ask Yield: 5.26%

Likes: make-whole call provision, 25bps coupon step-up for every downgrade, 455bps+ spread over 5yr US Treasury

Dislikes: 9% drop in steel-sector demand in the EU in 2012 (Reuters)

These represent a very small sample of securities that are not necessarily investment grade, but are reputable and would widely be considered ‘safe.’ For more info on these or other names please give us a call. “BB” Land may very well become a sweet-spot for you!

For more information, please contact us at info@firstlinesecurities.com

Gerard Stephens

Account Executive

Sales and Trading

The S&P Annual Global Corporate Default and Ratings Transition Study provides tremendous insight into (you guessed it) defaults on rated and unrated bonds all over the world, as well as a panorama of ratings transitions (upgrades and downgrades).

The 2012 edition was released late March this year and there are a number of compelling statistics that can help frame your bond portfolio moving forward. Let Firstline help you construct a portfolio that includes investment grade Latin American corporate bonds, which offer some of the best yields along with default and credit risks similar to their American or European counterparts.

GLOBAL RATINGS 

Interestingly enough, in 2012 defaults increased not only in number, but also in the dollar value compared to the previous year. There were 84 defaults in 2012, covering debt with a face value of 87 billion—compared to 53 defaults worth 84 billion in 2011. 

The majority of defaults where in the CCC to C rating range, where 26.62% of issues defaulted in 2012. There were zero defaults in investment grade bonds (rated between BBB and AAA). BB-rated bonds registered default rates of 0.29% while 1.5% of B-rated bonds defaulted during the same period.

The latest figure on cumulative default rates is instructive; over 50% of all CCC or lower debt ever issued has defaulted, while the lowest category of investment grade (BBB) has yet to scrape a 10% cumulative default rate.

That being said, defaults on speculative or non-investment grade credits came in at 2.2%, well below their 32 year average of 4.2%. This is reflective of a larger distribution of higher end speculative grade bonds (BB+ to B-) versus the lower end (CCC+ to D).

No single industry had a default rate above 5% but Leisure/Media, Transportation, Energy and Natural Resources, and Utilities were well above their long term average.

Utilities in particular had a default rate that was more than double its historical rate of less than 0.5%. The industry with the lowest default rate was real estate, which had zero defaults, with insurance in second.

Overall stability deteriorated somewhat, largely as a result of events in Europe and an unsteady global recovery. 8.2% of issuers were upgraded, while 11.76% were downgraded.

US RATINGS

The U.S. saw a marked decline in the dollar value of defaults, at 39 billion down from 74 billion in 2011. However, in raw numbers, there were 47 defaults compared to 39 in 2011. The overall default rate for U.S. issuers was 2.6%, compared to the long term average of 4.5%. Almost nine out of ten (85%) defaults were from non-investment grade issuers.

Almost a third (29%) of issuers rated CCC or worse defaulted in 2012, above the historical average. Overall non investment grade default rate was 2.59%, compared to 2.01% the previous year. There were no investment grade defaults, while there were 39 non investment grade defaults.

The U.S. is home to most speculative / non-investment grade issuers, and in fact, 52.6% of U.S. issuers are non-investment grade. Additionally, 54% of all non-investment grade issuers globally are based in the U.S.

In stability terms, 75% of issuers had no change in rating (versus 70% in 2011). Upgrades in the U.S. also outpaced downgrades for the third consecutive year; 8.74% of issuers were upgraded, while 8.16% were downgraded.

EMERGING MARKET CORPORATE RATINGS

Emerging Markets defaults increased the most out of all categories, from 4 defaults in 2011 to 25 in 2012—although to be fair, the EM category includes issuers from 84 different countries. Around 30% of all global defaults were in emerging market countries.

This is only the fourth time in the past 16 years that the emerging markets default rate is higher than the global default rate. The previous three times (1998, 1999, and 2002) coincided with sovereign stress periods in emerging markets. These were the Asian financial crisis and the sovereign crisis in Russia in 1998 and the default of Argentina in 2001.

 The dollar value of defaults in 2012 for EM was 22 billion. This is an enormous increase from the 2011 dollar value of defaults, which was only 180 million. BTA Bank J.S.C., a Kazakh bank, was the single largest defaulter globally, with 10 billion.

There were no investment grade defaults in emerging markets, in line with the global norm, and also below the EM historical average of 0.21%; non-investment grade defaults were 2.56%, below the historical average of 3.59%. Cumulative default profiles for EM mirror that of global issuers, although interestingly, there is actually a lower default rate for non-investment grade names.

In terms of industries or sectors, Brazilian utilities had the highest default rate in 2012, at 3%. This is also reflected in the regional breakdown, where 11 out of the 25 EM defaulters were based. Eastern Europe, the Middle East, and Africa (EEMEA) was second, with 9 defaults.

Additionally, credit stability deteriorated, with 10.6% of issuers in emerging markets having been downgraded in 2012. This is an interesting contrast to the price performance of EM bonds, which have outperformed most other fixed income asset classes. Could it be that there is a bubble? Or are EM corporate issuers simply becoming more creditworthy?

CONCLUSION

Based on data from last year, it seems that credit has improved for most global issuers, with the U.S. showing particular signs of robustness. This robustness is mirrored in equities as well, and has led to record highs in the stock market to match record performances and low yields in bonds.

However, questions remain regarding the strength of the global economy—particular the consumer. Unemployment is still quite high, and wages remain depressed in inflation-adjusted terms as well as in proportion to record high corporate profits. If interest rates go up quickly as a result of growth, along with inflation and increased hiring, the U.S. could find itself in a Catch 22 situation.

Profit margins could take a tumble, squeezing creditworthiness and leading to higher defaults. Additionally, Europe will continue to be a drag on growth and the political establishment on the continent has had an uneven, last minute approach to dealing with problems.
Nevertheless, there are many high quality credits, especially in the Latin American corporate sector, which offer excellent yields compared to other options, while also tapping into robust (and growing balance sheets). Firstline has spent the last few years developing expertise in this area and we can help build a portfolio that suits your risk tolerance and needs.

In the next installment we will tackle European corporate and global sovereign default rates.

However, in the meantime, and for more information, please contact us at info@firstlinesecurities.com.

Michael J Cooper
Trading / Investment Strategist
Firstline Securities Limited

Quarter-end is here once again. Institutions are either window dressing away or sitting back and smiling at their performance over the period. More importantly it’s a time to reflect on what could have been in terms of missed targets: Maybe it takes more than one shot to hit the Bullseye?

Recently, we previewed Petrotrin 2019s in our last ‘Sovereign Indicative Levels’ for those of you that receive and/or study it, but these warrant a second look, perhaps even a third or fourth.These bonds have traded 17 points higher since October 2011! (That’s right- 17% in less than 2 years), when the Euro-crisis reached its boiling point.

Are they overbought? This is a sensible question, but for me it deserves a resounding ‘NO!’ The recent 1-2pt decline in price is really a function of the market, (thanks to Cyprus, and Europe in general). Perhaps the brief strike action motivated some holders to sell, but the company remains crucial to this country’s livelihood. Furthermore, we cannot ignore the superior liquidity compared to other Caribbean credits … especially high grade names such as Trinidad & Tobago, Cayman, Bermuda etc. The issue size is more than 3x that of TRITOB 2020s (850mm vs 250mm), is wholly owned by the government of Trinidad & Tobago (rated A/Baa1), and today provides a pick-up in yield over 132bps.

So which would you rather, sit on your hands and wait for supply on the pink unicorn that is TRITOB to emerge,

or look at a bond that offers perhaps the best balance of tenor, credit quality, liquidity and yield in the region?

Let’s take this conversation out of the Caribbean context. What if I said PETRTT 19s outperform their LATAM counterparts when it comes to bonds of a similar tenor?

I know, your cynicism is getting the best of you … until, of course you see these pick back up and gather steam. Since issue, PETRTT 2019s have steadily trended upward, with a ‘sub-trend’ of price declines ->  spells at which prices appear to be sticky-> price increase. The graph below illustrates just this point.

Courtesy Bloomberg

So, what say you? Is it now time to pick up bonds cheaply vs their YTD level? I’d say so, especially since portfolio managers are likely to offload some of their exposure to show decent cash balances at quarter-end. While you may be tempted to see how low they can go, don’t be surprised if Q2 finds you buying into the rally.

We’d be happy to keep you abreast of the market on these and several other sovereigns and corporates.

For More Information, Please Contact Us At Info@Firstlinesecurities.Com.

Gerard Stephens
Account Executive
Sales And Trading

The world was shocked to learn on March 5^th, 2013 that Venezuela’s President, Hugo Chavez, had succumbed to cancer after a protracted two year battle. Election dates have now been set for April 14^th, 2013. Henrique Capriles Radonski will face off against President Nicolas Maduro, Chavez’s anointed successor, to determine who will complete the rest of Chavez’s six year term which began in January. While Capriles suffered an 11 point defeat in December, the outcome of the April election is far less certain and likely to be a much closer race.

Venezuelan bonds were among the best performing fixed income investments in 2012, driven largely by the expectation that Capriles would win the election and shift Venezuela’s economy—particularly its behemoth oil company, PDVSA—in a more market-oriented direction.

However, a cursory analysis of the presidential campaign and broader political situation in Venezuela would have shown that Capriles had only the slimmest chances of winning the election. As a result, Venezuela risk tumbled and yields pushed back up, albeit temporarily.

1 year PDVSA 2014 graph

Despite winning the election, Chavez slowly receded from public view as rumours mounted of his deteriorating health. Yields started to come back down and Venezuelan bonds rallied into the end of the year. Chavez’s passing initially put a small dent in the rally, as it was unclear whether there would be another election or not. After the date was set, strong momentum came back due to the perception that Capriles may have a fighting chance in the upcoming election.

With 297 billion (yes, with a b) barrels, Venezuela currently sits on the world’s largest proven oil reserves. Reserves may increase by hundreds of additional billion barrels as more thorough assessments of the Orinoco basin provide a clearer picture of the heavy crude potential in Central Venezuela.

However, given a history of asset seizures and contentious commercial arbitration, many international companies have been reluctant to invest in Venezuela. Additionally, PDVSA lacks the capital to undertake the mining, refining, transportation and waste disposal for the heavier crudes, and would first need to focus on boosting short term conventional oil production, which has declined somewhat in recent years.

Interestingly enough, for all of Chavez’s firebrand rhetoric against Western imperialism, Venezuela has yet to default on any of its debt since the Bolivarian Revolution was launched in 1998. Even during crisis periods, such as the 2004 referendum, the failed coup d’etat in 2002, or the 3 month national strike in 2002-2003, Venezuela has continued to pay its debts. This is largely a function of huge domestic demand for U.S. dollars, as well as an ongoing need for capital expenditure funding at PDVSA as well as funding for the many grassroots-oriented social initiatives (or “Missions”) across Venezuela.

Capriles

The perception is that the upcoming election will greatly affect how Venezuela spends its money; but a deeper analysis would reveal that Capriles cannot and will not immediately roll back many of the social programs instituted by Chavez. Capriles is far from a gung-ho free market capitalist, but could be best described as a younger, hipper Venezuelan spin on Luiz Ignacio da Silva (better known as Lula), the Brazilian President who successfully balanced growth-oriented and people-oriented policies in Brazil during the 2000s.

Maduro

A Maduro victory would see continued and perhaps even expanded social spending as he would seek to endear the public and establish a legacy apart from Chavez. Maduro is a soft-spoken former bus driver who has served in many senior level positions, including Minister of Foreign Affairs. He is a stalwart Bolivarian, who was handpicked by Chavez over a number of other ‘obvious’ choices for successor. Before his demise, Chavez began to take a relatively conciliatory tone towards former antagonists, and Maduro is expected to continue in that vein while remaining committed to revolutionary principles.

Nagging and persistent distrust of the traditional elite will continue to be a major headwind for Capriles, while doubts regarding Maduro’s acumen and charisma will plague the Chavista camp. However, in either scenario, Venezuela’s credit picture remains roughly the same, with marginal (and overestimated?) improvements to be expected if the opposition wins.

The market has more confidence in Capriles, but as a young and relatively unproven politician in a politically polarized and economically vulnerable nation, there is much that can go wrong. Nevertheless, given strong oil reserves and pledges from both candidates to increase production, coupled with increasing exports to China, even under Maduro the credit picture has a chance of improving.

Additionally, based on World Bank statistics, Venezuela has fairly strong fundamentals, as of 2011: a US$316 billion dollar local economy, with a debt to GDP ratio of 45%, and foreign reserves of US$ 27 billion dollars, although much of that is in gold. Looking at actual figures, it is clear that most of Venezuela’s risk premium derives from its political risk—yet the Bolivarian regime has yet to renege on its obligations. The sum of these factors make Venezuela a buy, even if the regime doesn’t change.

A Maduro win would prompt a sell-off in the bond markets, which in turn may present a buying opportunity for savvy investors. Outside of country risk, interest rate risk should not be ignored but focusing on the shorter maturities could provide excellent options for yield and price appreciation over the next year—albeit not without volatility.

For more insights and detailed analysis, please contact Firstline Securities at info@firstlinesecurities.com.

While volatility, risk and big sell offs are associated with the stock market, the bond market is really no different—like any other market, it eventually succumbs to gravity. There are several catalysts for this reversal of momentum, including the end of easing,

It is no secret that yields are at historic lows, primarily due to zero interest rate policies (ZIRPs) and quantitative easing (QE) by the Federal Reserve and other central banks in the developed world. Safe haven demand, especially after the brutal volatility at the end of 2008 going into 2009, is also driving bond yields to record lows. As the economy and corporate sectors have stabilized and generated surplus cash, most of it is being invested in bonds, specifically bond funds.

However, ZIRP and QE are not going to continue indefinitely! While the Federal Reserve has stated that they will keep rates low through 2014, recent meeting minutes suggest that the Fed will begin increasing rates if unemployment crosses the 6.5% threshold. Levels are currently hovering around 8%, with a recent stall due to increased political risk and Hurricane Sandy. Expectations are that many of the political risks are dissipating, and underlying strength in housing, energy and other sectors in the U.S. will lead to more jobs and less unemployment.

Additionally, investors have been catching on to the fact that equities have been in a monster rally since 2009—what I like to call the Rodney Dangerfield rally, because it gets no respect. Corporate profits and cash are at or near to all time highs in the market, yet it has taken years for the fear to dissipate. This is reflected in mutual fund flows into bond funds versus stock funds.

In the 2012 calendar year, US$ 285.5 billion (net) flowed into bond mutual funds, while US$ 100 billion (net) flowed out of stock mutual funds. This trend has been consistent for most of the years since 2008, but 2012 represented the climax of bond buying. However, starting in November 2012, the tide started to change.

According to EPFR Research, which tracks fund flows, if we used November 21^st as the starting point, and the last week of January as the end point, US$ 94 billion (net) flowed into stock mutual funds, while bond mutual funds received net inflows of US$ 35 billion. Stock mutual funds had their third best week of inflows ever, in the last week of January while the only segment of the bond market that is sustaining its level of inflows is Emerging Markets debt which has seen 34 straight weeks of net inflows.

The flow of funds is but one of the reasons why U.S. 10 year Treasury yields briefly surged above 2% at the end of January, visiting levels not seen in almost a year.

Yet, as seen from the 5 year chart, there is substantial room for yields and rates to go up further. This would impact VERY negatively on your portfolio if there is a high concentration in bonds and fixed income instruments, especially if you are holding the longer maturities (past 10 years).

DV01 is a metric that quantifies the dollar risk in duration; it is the amount of money that will be lost for every 1 million dollars invested in a fixed income instrument. DV01 for investment grade names in fixed income are in the US$ 770 area, well above their historical average of around US$ 600, according to data from Citi. DV01 has already been higher than US$800 in 2013, and because of their direct relationship to yields, will go back up if rates or inflation increase.

It goes without saying that record low yields coupled with dollar duration risk at multi-decade highs are not a good combination.

Dan Fuss, a low key but stellar bond fund manager who oversees $66 billion in assets at Loomis Sayles, in a recent interview on Bloomberg said that he has never seen a bond market that is so overvalued in his 55 year career. “What I tell my clients is, ‘It’s not the end of the world, but for heaven’s sakes don’t go out and borrow money to buy bonds right now,’” Fuss said, due largely to valuations he characterized as “ridiculous,” particularly in the new issues market.

Investment strategists at major investment banks such as Goldman Sachs and Citi have also sounded the alarms, not just due to fundamentals and the end of quantitative easing, but also due to the current structure of the fixed income market.

With regulatory changes and other shifts in risk appetite following the crisis, many broker dealers and investment banks have minimized the amount of fixed income inventory they hold on their balance sheet. This was part of the deleveraging that many institutions underwent in the wake of Lehman’s collapse.

In turn, funds and particularly exchange traded funds (ETFs) have become major players in the fixed income landscape, more than picking up for the slack from the banks and broker dealers. However, the ETFs have primarily been buyers until now.

Given that there has been so much overwhelming buying volume (the fund inflows), and that banks and dealers are now reluctant or unable to hold too many bonds on their balance sheet, what would happen in a scenario where rates or inflation expectations rise?

There would be a rush for the exit. Many of the funds and other institutions that have gorged themselves on hundreds of billions of dollars of bonds, like Life Insurance companies, would try to sell into that environment. But who would buy an overpriced bond with low yield and high dollar duration risk? Will banks get stuck catching the falling knives of the bond market? Those questions are difficult to answer, but it is even more difficult to see how they can be answered affirmatively.

Will there be a meltdown or will there be an orderly decline in the debt markets? It depends on whether you worship at the altar of Murphy’s Law. There is a saying about markets: that they can remain insane longer than you can remain solvent. There are arguments against a bond market collapse: many corporate and sovereigns have ample cash and may not need to issue debt; the economic recovery could stall, and in fact we could end up in another recession or financial crisis; war could break out between Iran and the West, or the situation in Syria can end up engulfing the Middle East in war, etc. These are all plausible scenarios.

The fact remains that there is very little upside in bonds, and the forces of gravity seem more and more inevitable with the passage of time: due to the end of QE and its potentially inflationary effects, due to high valuations and duration risk, and due to renewed confidence in the economic recovery and upside potential in equities. While there are scenarios that could support the bond market, such as the ones described above, they still remain less likely to happen.

Very few analysts believe that the credit markets will unravel tomorrow. But even fewer dispute that it is looking overheated, and many of the conditions that made it outperform in the past five to ten years are unsustainable.

Investors are advised to remain vigilant. Firstline is crafting strategies internally to grapple with some of these risks, and we are happy to discuss them with clients.

For More Information,

Please Contact Us At info@firstlinesecurities.com.

Michael J Cooper
Trading / Investment Strategist
Firstline Securities Limited

A time to reflect? Without a doubt! 2012 was one to look over with astonishment, as Olympics, bond bubbles, stock market recoveries, elections and health scares ruled everything from traditional to modern (social) media. Here are a few items which were of particular interest;

# Elections: US, China, Japan, Venezuela

Voters and electoral colleges alike had quite a busy 2012. Chavez’s re-election saw PDVSA/ Vene bonds take a substantial hit (5-10 pts), but these have recovered nicely and there’s no doubt that holders took some nice profits on these going into the New Year. As usual with PDVSA/ Vene, keep an eye out for a lot more volatility. Chavez has named a potential successor in VP Nicolas Maduro amid significant and frequent cancer treatments.

PDVSA 2014 – worth the risk? 15pts+ says ‘Yes’

In Japan, stocks lifted higher with the Liberal Democratic Party making a return since 2009. The LDP won 294 seats in the 480-seat lower house of parliament, and the victory marked the renewal of hopes that Japan’s economy will recover and Japan – China relations will improve. Testament to this anticipated revival is traders going short JPY and long the Nikkei.

Japan – A Source of Growth…Again?

Speaking of China, Xi Jinping is set to take over the reins from Hu Jintao in March 2013. Same party, new politics? Dubbed the ‘casual communist’ by one newspaper because of his relatively genial style, we’ll have to wait and see exactly how the administration will oversee China supplanting the U.S. in terms of total GDP. While there remains quite a bridge to gap in terms of average prosperity, the relationship between the two nations is certainly symbiotic (Shanghai Institute of International Studies).

Republican Presidential Candidate Mitt Romney in no way mixed matters on his stance on China’s trading practices, and manipulation of its currency. This takes us to the U.S. and one of the most fiercely contested elections in recent history. While Obama enjoyed an Electoral College blowout, the popular votes told a very different (and divided) story. Stocks declined heavily on the days immediately after Obama’s victory, with markets uncertain as to how the nation’s debt would be reduced. Even more glaring is the lack of a definitive solution on the ever-frustrating fiscal cliff.

# Political Dysfunction: Fiscal Cliff and Glacial Pace of Action in Europe. Getting Off The Edge, While Kicking The Can

How comfortably can you sleep while trying to hang onto a crumbling cliff? Just ask the U.S., but I’m not sure if you’ll actually get an answer.

Will there be compromise, and more importantly when? The cancellation of the last House vote (even Republicans didn’t agree with Boehner’s plan) was enough to send markets down, so let’s hope that some consensus can be achieved ASAP!

Across the pond; what’s up with Europe? After Merkel and Sarkozy graced headlines for the better part of 2012, Europe still has many an investor guessing as what comes next.

France saw Francois Hollande defeat Sarkozy in the polls, and Hollande’s 75% millionaires tax should be mentioned here as well, as it’s an extreme case of the tax- the- rich debate in the USA associated with the fiscal cliff. With this tax plan likely to be shelved, so Finance Minister Pierre Moscovici certainly has his work cut out.

Greece self- sabotaged their recovery, and has left us wondering; would have it been better if they were left to default and fend for themselves? Given the implications for Euro stability, it’s hardly likely that a lot would’ve been done differently even in hindsight. Spanish banks featured heavily as well (for all the wrong reasons), as the Spanish government reported that there is a €59.3bn shortfall in its financial sector.

Italy may continue to be the next trouble spot after Mario Monti resigned, which makes for a very interesting 2013!

# The Invisible Rally/Recovery: On The Rally/Recovery – Are You On Board?

Go against the grain, and more often than not you’ll come out ahead of the game. The bond market certainly had a stellar year but let’s not forget that the S&P 500 rose over 13% YTD, which means that equities was this year’s loudest ‘sleeper hit.’ Look out for the sequel in 2013. Concerns that the U.S. is still (and will sink back) in a recession are warranted, and compounded by mounting debt, but improving jobs numbers and increasing confidence may pave the way forward.

# Cracks In The Bond Market: Brief Discussion of How Bonds Have Started to Underperform, And Talk Of The Bond Bubble

Let me tell you, 2012 was a great year for fixed income, helped in no small part by the volatility caused by Europe. Several new issues, namely from LATAM (many of which were oversubscribed), were absolutely devoured by investors. Even in the Caribbean, Aruba and Bermuda issued bonds due 2023 but demand on Aruba has curiously been on ‘slow-go.’ We feel this will change after the customary year-end window dressing.

Since July/August, there haven’t been many slam dunks or layups available on the bond market though, as that optimism which marked the beginning of 2012, started to wane steadily. Of course there’s still value in the bond market, but trading on the secondary market is likely to see far more activity rather than the new issue craze. The bond bubble has to pop sometime, just like any other…tulips, tech, dot com etc.

# Zero dark Infinity: Quantitative Easing Globally, And “Financial Repression”

‘Easing,’ ‘Operation Twist,’ ‘Accomodative’…just a few of the expansionary buzzwords that came your way throughout 2012. In T&T the repo rate stands at a paltry 2.75%, which goes to show just how strong the emphasis is on helping the global economy get back on its feet. Bernanke has more than hinted that rates are set to be low until 2014 (if not later).

Will more sovereigns and corporates continue to issue bonds in the low-rate environment? T&T for one, has long been rumoured come out with another USD-denominated bond to no avail.

But these low rates aren’t driven by demand and supply right? Definitely not! This repression can lead to asset booms/busts, uncontrollable bouts of inflation, sudden stops in economic activity from loss of confidence, or capital flight (PIMCO).

# Locally: Political And Economic Inertia, Promising Budget, Increasing Energy Sector Activity, The Beginning Of Internationalization

On the local front, the 2012/13 budget gave us several talking points; few as over-analyzed as the removal of VAT on several food items, and the increase of the ‘Premium’ gas price. While the budget was set to be one of austerity according to most sources, prevailing economic conditions had the final say. A rising food –import bill continues to play its part in inflation figures which currently stand above 8%.

In terms of direction, however, much has to be done to achieve diversification away from the energy sector. In that vein, other energy destinations have been mooted; namely Ghana, Guyana and French Guiana. 2011 saw National Gas Company (NGC) selected by the Ghana National Petroleum Corporation in a competitive bid for a project to supply energy to power plants in Ghana (Reuters). To our knowledge, NGC has not followed up on this contract, but similar ventures outside T&T would be welcome sources of revenue going forward.

I know, I know – a lot to take in all at once. 2012 was just that type of year, but I would say that most economies are grateful for what was (by and large) a year of recovery. Investors clung onto their bonds for dear life, while adjusting their rate expectations, but we expect some migration in equities very early into 2013.

Does the picture represent you, the investor, seeking opportunity in “stormy waters”?

In this instance I wasn’t going for something quite so profound but can you ‘Spot the difference?!’ I’m sure you’ve played this game countless times when you were younger, but are your eyes similarly trained to pick out quality investments apart from the ordinary?

Let’s put this into perspective with two recent issues:

Government of Bolivia

Ratings excerpt (Reuters):

“”Bolivia’s ratings incorporate its moderate inflation record, declining dollarization, healthy banking system and stable currency regime,” Fitch said in a statement…

However, the still heavy reliance on commodities for economic activity and a lack of transparency on the health of an unregulated financial sector pose risks of contingent liabilities to the government.”

Gov’t of Aruba

Reuters: S&P – “Aruba’s status as a colony of the Netherlands, prosperous economy with per capita GDP of about $25,000, stable democracy, high level of social development, and strong government balance sheet support its creditworthiness. A narrow economic base, limited monetary and external flexibility, and a sizeable gross general government debt burden (which is more than offset by public sector pension assets) are credit constraints…

The recent decision by Valero, the owner of the island’s oil refinery, to suspend operations was a setback to the economy and to the government’s fiscal plans to reduce its deficit in coming years. The refinery, which directly and indirectly employs about 5% of the island’s workforce, is the largest single private-sector employer.”

Bolivia’s major industries include mining and manufacturing and prospectively large natural gas exports, while Aruba is a significant tourist destination, executes oil refining and storage, and has a developing offshore financial sector.

A comparison of political and expropriation risk clearly favours Aruba. Bolivia’s president Evo Morales is known for confiscating/ nationalizing significant foreign-owned enterprises.

So why does Bolivia (even with a shorter life) yield only 28bps higher than Aruba? GREAT QUESTION! What may go some way in explaining this, is the bond bubble we’re currently experiencing. However, this will come to an end at some point…some say as soon as 2014. Furthermore, LATAM’s new issues have been consistently oversubscribed in the range of 2X – 5X this year. Lastly, this was Bolivia’s first international bond issue since 1920.

What that doesn’t change, however, is the significant gap in credit quality between these two bonds. The sentiment amongst many traders is that ARUBA 23s are significantly undervalued and when the haze clears after this ‘storm’ of new issues, they will be in heavy demand. We urge you to do your own research, but it seems like a no-brainer…stable economy, SIX rungs higher than Bolivia on the credit rating scale, and there is size available for your institution to soak up that excess liquidity (for now). We feel that the 4.00% – 4.50% range is where you should be looking for solid, investment grade,10-year paper. Let us have your thoughts, we’d be happy to hear them!

For more information, please contact us at info@firstlinesecurities.com.

Gerard Stephens
Account Executive
Sales and Trading

“Colombia may be on the threshold of a new era in its history—and massive opportunities for investors.”

“With the first official peace talks in almost a decade, there is renewed hope that one of Colombia’s major guerilla movements could disarm en masse and abandon their five decade war against the central government. A truce would provide even more momentum to Colombia’s economic outperformance which has made it the second largest economy in South America after Brazil (of course, Argentina disagrees). Yet regardless of the outcome, the market is signaling that the country could get a credit rating upgrade in the next year if it continues on its path. Firstline can help position you to benefit in either scenario.”

After several months of going back and forth, the Colombian government, headed by President      Juan Manuel Santos, is now engaged in formal peace talks with the Revolutionary Armed Forces  of Colombia, best known by their Spanish acronym, FARC. This has wide ranging, positive implications for the Colombian economy and will make an already attractive country even more palatable for investors.

The FARC, a Marxist guerilla group, has waged war on the central government for almost five decades in what has become the longest running armed conflict in the Western Hemisphere. The FARC has claimed responsibility for several acts of terrorism, in addition to guerilla attacks on police, army and other government armed forces. They also employed kidnapping of civilians as a means of raising funds, through ransoms. Lastly, they were heavily involved in the production and distribution of illegal drugs, which repeatedly brought them into conflict with other groups engaged in those activities.

The human, psychological and economic tolls of the conflict were enormous. Economically, the violence in Colombia was a major deterrent for local consumers, as well as local and international investors. Additionally, the government was forced to spend billions of dollars on defense over several decades. Those funds could have gone towards improving health care, infrastructure, education and other goods that would have contributed to the economic growth of the country.

However, the last decade has seen substantial improvements in the security situation, first under President Alvaro Uribe, and continuing under the current President, Juan Manuel Santos. Economic growth has helped draw many lower income Colombians away from the drug trade and guerilla movements, while amnesty, counterterrorism and intelligence initiatives have been fruitful in debilitating various armed factions in the country. The combination of these and other factors have led the FARC, which is the largest organization of its kind in Colombia, to peace talks which began October 18^th in Oslo, Norway, and will transition to Havana, Cuba, with time.

If the FARC agrees to peace terms, it will signal the end of this conflict. Expenditures previously earmarked for defense will go towards internal investment. The security situation will improve dramatically, especially in the Southeastern regions where the FARC is strongest—and where there are substantial unexploited oil, heavy oil, and gas reserves, in addition to gold and fertile farmland that could see the emergence of large scale agribusiness.

Mauricio Cardenas, Colombia’s Minister of Finance, anticipates that if the peace talks are successful, Colombia’s GDP could grow at ‘Asian-like’ rates of 6% per annum or more. That statement might seem hyperbolic. However, when we consider that Colombia has spent between 3% and 4% of GDP on military expenditure over the last decade, and that it has also grown at 5% since the security situation started improving in the early 2000’s, it seems very achievable—a 20% reduction in average annual military spending of US$ 10 billion would yield an additional US$2 billion that the government could redeploy into other uses that would accrue more direct economic benefits.

Colombian issuers, in particular banks have been very active in issuing new bonds this year, and bond markets have embraced all of their issues. Bancolombia, Grupo Aval, Banco Davivienda, among others, had issues that were six to eight times oversubscribed. As of late September, Colombian corporate bonds had a spread of 301 basis points over the US treasury, and have tightened 101 basis points since the beginning of the year. Contrast this with Brazil’s corporate spread, which is around 386 basis points above the treasury despite being one notch higher in credit ratings. The lower spread can be attributed to Colombia’s higher growth rate, and slightly better fiscal position—which positions the country well for an upgrade, even without a positive outcome from the talks, which are likely to be just the beginning of a longer, drawn out process.

However, savvy investors position themselves at the vanguard of trends, as that is where the lion’s share of profits is made. Firstline has considerable access to market intelligence on Colombia bonds, and solid experience investing and trading in them across several time frames. We can leverage that experience for your portfolio, helping you achieve higher returns in this low return environment while minimizing the risk to your principal. For more information, please contact us at info@firstlinesecurities.com.

Michael J Cooper
Trading / Investment Strategist
Firstline Securities Limited