PCY - PCY: Way Too Risky Now And Better Options Anyway

2023-10-23 17:38:41 ET

Summary

• Invesco Emerging Markets Sovereign Debt ETF is a high-risk investment due to its exposure to non-investment grade bonds and sensitivity to interest rates.
• The fund has a relatively high expense ratio compared to its peers, potentially impacting investor returns.
• Risks include potential defaults by issuing governments, the impact of a stronger U.S. dollar, and a global credit event.

I don't think about taking risks anymore because there aren't any risks to take. - Jim James.

Let's not bury the lede - I believe we are in a credit event, and if I'm right, emerging market debt is the last thing I think you want exposure to. This is why the Invesco Emerging Markets Sovereign Debt ETF ( PCY ) is one to avoid for now, but keep on your watch list for a tactical trade after the dislocation I think we are in is finished.

Introduction

PCY is designed to track the potential returns of a portfolio of liquid emerging markets U.S. dollar-denominated government bonds issued by more than 20 emerging-market countries. This exchange-traded fund ("ETF") is ideal for investors seeking exposure to the sovereign debt of emerging markets, which can offer attractive yields and potential for capital appreciation.

Its bonds are issued by governments or government-owned corporations in these markets, and they have remaining maturity of at least three years. The fund is highly diversified across various emerging economies, with the top five exposures accounting for a little over 8% of the fund.

Credit Risk

A significant portion of PCY's investments are in non-investment grade bonds, also known as junk bonds. These bonds carry a higher risk of default but offer higher yields to compensate for this risk. This is why I am nervous about a fund like this, as I do suspect we could see some emerging markets potentially default on the lagged effects of the fastest rate hike cycle in history.

Peer Comparison

When compared to other ETFs in the same category, PCY stands out for its high exposure to non-investment grade bonds and its high duration. However, it also has a relatively high expense ratio of 0.50%, which is more than double that of some peers like the Vanguard Emerging Markets Government Bond Index Fund ETF Shares ( VWOB ) which has a net expense ratio currently of just 0.2%. This could potentially eat into the returns for investors.

It's also worth noting that when comparing PCY to VWOB, the price ratio is in a steep downtrend now, with it very far from its 2016 peak.

Potential Risks

Investing in PCY carries several risks. The primary risk is the potential for default by the issuing governments. If a government defaults on its debt obligations, it could significantly impact the value of the fund. Moreover, the fund's relatively higher duration means it's highly sensitive to changes in interest rates. If rates continue to rise, the value of the bonds in the fund's portfolio could drop aggressively, hurting the fund's performance.

Another risk to consider is the impact of a stronger U.S. dollar. If the dollar continues to rise, it could put pressure on emerging market economies and their ability to service their dollar-denominated debt, potentially leading to defaults. Lastly, the global credit environment poses a risk. If a global credit event occurs (as I surmise is underway), it could lead to a sharp selloff in emerging market bonds, impacting PCY's performance.

Conclusion

While the Invesco Emerging Markets Sovereign Debt ETF offers an attractive yield and exposure to emerging markets, it comes with a high level of risk due to its exposure to non-investment grade bonds and sensitivity to interest rates. Considering the potential for rising interest rates and a stronger U.S. dollar, as well as the current global credit environment, investors should approach this fund with caution.

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