Friday, June 19, 2009 2 comments ++[ CLICK TO COMMENT ]++

Sovereign credit ratings

Here is a map, courtesy BusinessWeek, of credit ratings for countries rated by S&P (as usual with images, click for a larger image):



If you were to invest in a foreign bond, which one would it be? I'm developing an idea I've been thinking about for a while now. The idea is to invest in Brazilian bonds (assuming it's possible) and keep rolling* them (say every 3 years).


(* You need to keep rolling them over to maximize capital gains. The reason you are investing, at least with my strategy, is for capital gains (not interest income.))

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2 Response to Sovereign credit ratings

contrariandutch
June 21, 2009 at 12:54 PM

Errr...

I may be a bit thick here, but how is this capital gains thing supposed to work? Are Brazilian bonds trading at deep discounts to par?

Sivaram
June 21, 2009 at 4:05 PM

No, it's not trading below any notion of an intrinc value. Rather, it's a bet on declining interest rates. It's just a very preliminary idea but here is my thinking.

Gary Shilling, the so-called perma-bear, supposedly became financially independent by investing in US Treasury bonds in the 80's and 90's (this was mentioned in John Mauldin's book, Just One Thing). I don't know the exact details but he suggested that his strategy was to take a long position and continuously roll them over (he didn't say but maybe every year or two.) He actually used leverage, which probably was not very risky given how he was dealing with US government bonds, but if one didn't use leverage, the returns would have slightly lower. Overall, though, rolling long-term bonds would have produced very good returns and may have even beaten stocks, except for a short period in the late 90's (I am guessing here.)

Essentially, he was betting on declining yields. Most of his return would have come from the capital gains arising from the decline in yields. I have to study this more but Shilling was saying that you need to keep rolling them over to keep duration long and maximize capital gains (i.e. if you bought a 20-year bond 10 years ago and kept it, it would only have 10 years left now whereas rolling it over preserves the long-term exposure.)


So, me being the 'always inquisitive but terrible investor' started thinking about how one can replicate this strategy. Unfortunately, bond yields throughout the world are near all-time lows. But some developing countries have high yields. I narrowed it down to Brazil, although I'm looking at other possibilities as well.

Short-term rates in Brazil are around 9% while long-term (8yr) are around 12% (Bloomberg data). This sort of gives some good starting figures. One probably needs a starting yield of around 10%. If one assumes the country develops itself a bit further over the next 20 years, its yield can probably drop all the way down to 5%.

I haven't done the research yet...will inflation will be brought under control? Brazil's fiscal management also seems to be better than many others. Brazil has a terrible history but if future governments follow the present government--always a big if, and heavily dependent on commodity prices--its bonds seem somewhat safer than many other developing countries.

One also needs to think about whether the currency will decline. I have to think more about this.

It's also not clear if Brazilian govt bonds can be easily purchased by small investors (with reasonably low commissions.)

Anyway, this is just an idea... sort of like my junk bond idea from late last year, which I never really executed...

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