Description

Like everyone else I look back to late 2021 and think it was beyond evident that things were stupid. I carried some cash and put on some hedges but never enough in hindsight.

I am in search of fire insurance while the house is burning at a reasonable price. I feel like the fire might get worse and it's now to a small roar which has brought pricing back to a reasonable level. The VIX has been retreating and markets have risen, thus pricing on “insurance” is getting more attractive. I’ll admit this is a more qualitative theme then quantitative.

I don’t have an ISDA so look to the public market for that hedge. I did well in PFIX but not enough “juice” to satisfy my demanding LPs.

Enter EMB – iShares J.P. Morgan USD Emerging Markets Bond ETF (EMB). EMB is liquid and as it’s names suggest an ETF for “emerging market sovereign debt”.

Top holdings are listed below:

KUWAIT STATE OF (GOVERNMENT) MTN

URUGUAY (ORIENTAL REPUBLIC OF)

ECUADOR REPUBLIC OF (GOVERNMENT)

QATAR (STATE OF)

BRAZIL FEDERATIVE REPUBLIC OF (GO

KAZAKHSTAN (REPUBLIC OF) MTN

QATAR (STATE OF)

PERU (REPUBLIC OF)

URUGUAY (ORIENTAL REPUBLIC OF)

PETRONAS CAPITAL LTD MTN

URUGUAY (ORIENTAL REPUBLIC OF)

SAUDI ARABIA (KINGDOM OF) MTN

QATAR (STATE OF)

PERU (REPUBLIC OF)

SAUDI ARABIA (KINGDOM OF) MTN

PETRONAS CAPITAL LTD MTN

SOUTHERN GAS CORRIDOR CJSC

ECUADOR REPUBLIC OF (GOVERNMENT)

JAMAICA (GOVERNMENT)

BRAZIL FEDERATIVE REPUBLIC OF (GOV

DOMINICAN REPUBLIC (GOVERNMENT)

For more granular statistics on duration, concentration etc. see here

https://www.ishares.com/us/products/239572/ishares-jp-morgan-usd-emerging-markets-bond-etf

In a world of 4-5% 10-year UST and 7+% 30-year Mortgages a 5ish% yield on this portfolio is grossly inadequate to compensate for the risk. There are already reports of a lumpy market for UST, and the episode on the UK Gilts a few weeks ago just highlights the risks for G-8 debt. In any market hiccup, I am pressed that a dealer will quote the 2045 debt of the “Republic of Ecuador” or Kazakhstan at a reasonable level. The price of EMB in that scenario is likely to cascade down rapidly, in what I think could be an intermediate “death spiral”

I feel like this instrument should trade much wider than it is to UST, 10 or 20 years. Given the interest rates you can get on the cash rebate, I think this is an attractively priced insurance policy.

A few different ways to play:

• Simple short of the ETF and then invest the proceeds to reduce the cost

• A pair trade against a better US risk, maybe long the LQD and short this

• This is big enough that there are listed options, that I think are attractive, and provide the “juice” I have been looking for.

If you think there is more chaos to come, the debt markets will likely seize in some way before the Fed blinks and that spillover always moves to the emerging markets debt space. With recent elections and protests across the globe I believe this risk is larger and bigger than is being reflected in this category of instruments. Inflation is causing those at the “bottom of the pyramid” to rise and destabilize their government and balk at their financial obligations. A 2045 obligation is hard to think about when you can afford food and fuel. This is as much a geopolitical hedge as an inflation/credit hedge, and I think it is being offered at an attractive price

Again, the options can’t be traded in size, but you get the picture. There are other Emerging market funds that you could trade in lieu, but I like this one because it is the most liquid.

Catalyst

Sh*t hits the fan