Under the Hood: What’s in Your Index? (An Ongoing Series)
Your Bond Index: Part of the ETF Bubble
Here’s a valuation sobriety test – but we’re going to avoid equities, because the value of almost any stock, even one with a P/E of 100, may be legitimately argued. Arguments for overvaluation don’t fall on deaf ears so much as get set side by side with all the other viewpoints, with a sort of moral equivalency applied to all.
Amazon.com Inc. (“Amazon”), for instance, who is to say what future sales and profit margins might ultimately be?
The valuation of bonds, on the other hand, is rather narrowly limited, and by fairly objective
criteria. A bond will be worth par (at most) by a given date, based on contractual obligations and usually rather observable balance sheet and cash flow data.
So, if one were told that a 10”year U.S. Treasury Note – essentially the benchmark for no”credit”risk, liquid borrowing – now sells for a 2% yield, and had to guess at the yield of a 10”year investment”grade corporate bond, like International Business Machines Corporation (“IBM”), which has a AA” Standard & Poor’s (“S&P”) credit rating, what extra yield would one require for a decade’s worth of the extra risk? A percentage point or so? That’s about right: a 10”year IBM bond trades at a 3.4% yield to maturity.
How about a non”investment grade, but recognizable credit, like the 10”year The Wendy’s Company (“Wendy’s) International bond, Wendy’s being profitable and able to pay its interest expense, but nevertheless rated CCC+? Another few points? That’s about right. The 10”year Wendy’s bond trades at a 6.3% yield.
As a check, the iShares High Yield Corporate Bond ETF (“HYG”) has a 6.6% yield to maturity.
So, the sobriety test will consist of several major holdings in the iShares Emerging Markets High Yield Bond ETF (“EMHY”), and the question for each will be: what should the yield to maturity be? Essentially, what price for the extra risk, bearing in mind that the best one can do is to recoup 100 cents on the dollar?
Answers will be provided at the end of the test. As a frame of reference, the weighted average maturity of EMHY is 9 years, comparable to the examples above, with a weighted average yield to maturity of 8.9%.
First up, Russian Federation 7.5% bonds due March 2030. This is U.S. dollar”denominated debt, as are all the bonds in this ETF, so there is no currency risk. Russian sovereign debt is rated BB+ by S&P. As to circumstances, there has been a sharp decline in oil and gas prices as well as gold, and the government needs that revenue to balance its budget, which it cannot do. In July, in respect of the budget, the government dismissed 110,000 employees.
Government spending is to be cut by 10%. The GDP should contract by 3.8% this year, according to the International Monetary Fund. What is the yield of this bond?
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