Summary
- PCY invests in sovereign bonds in the emerging markets.
- Sovereign debt default rates will likely remain elevated in 2023.
- Despite offering a yield north of 8%, the fund may underperform in an economic recession.
ETF Overview
Invesco Emerging Markets Sovereign Debt Portfolio ETF ( PCY ) focuses on sovereign bonds in the emerging markets. These are bonds issued by governments or government-owned corporations in the emerging markets. Sovereign debt default rate is expected to remain high in 2023 due to Federal Reserve's aggressive hike in 2022 and its policy to keep the rate elevated. In addition, the likelihood of a recession may weigh on market sentiments and result in PCY’s underperformance. Hence, investors should not own PCY right now.
Fund Analysis
PCY was beaten in 2022
Investors owning PCY must be disappointed as the fund delivered a total loss of 24.44% in 2022. This underperformance in 2022 was primarily due to the Federal Reserve’s aggressive rate hikes last year. The Federal Reserve’s fund rate increase will normally result in money flowing from other parts of the world back to the United States. Emerging markets with trade-deficits and high level of debts tends to get hit the hardest. These countries already have liquidity issues and the rise of rates will increase the cost of borrowing further dries up the liquidity. Hence, bond prices tend to drop. This explains why PCY’s fund price was on a sharp decline last year.
Things got a bit better towards the end of last year and the beginning of this year. Though still high, inflation concerns in the U.S. have receded and the market has since become much more optimistic. Like equities, the bond markets in general have also rebounded. PCY’s fund price also saw some recovery, but is still down more than 26% since the beginning of 2022.
Default rate has climbed significantly in 2022
Since we are only about 1.5 months into 2023, we still do not have the official figure of the default rate of sovereign debts in 2022. Fortunately, JP Morgan and Neuberger Berman have come up with their estimates for last year. According to them, 2022’s sovereign default rate was expected to reach 7.5%. Although this rate was lower than the height of the pandemic reached in 2020 as illustrated in the chart below, it was still way above the average in the past 25 years.
We think the worst has yet to come
While we do not know what the default rate will be like in 2023, we do know that Fed fund rate will likely stay elevated or slightly higher throughout 2023. Therefore, we think it is likely that the default rate may also remain elevated. This will impact PCY’s net asset value negatively.
The reason we think the Federal Reserve will keep the rate elevated or slightly higher from the level today throughout 2023 is because inflation remains a big concern. While inflation has declined considerably since reaching the peak in mid-2022, it is still far from reaching the long-term target of 2%. January’s headline CPI growth of 6.4% was only down slightly from December’s 6.5%. The Federal Reserve’s preferred measure for CPI growth excluding food, energy and rent inflation has remained unchanged at 4.1% for three consecutive months. While goods spending has softened and services spending came to a halt towards the end of 2022, the labor market was still quite strong. Therefore, we do not expect the Federal Reserve to lower the rate soon. Any rate drop will be a story beyond 2023. There is also the risk that the Federal Reserve will continue to raise rates in the next few months, albeit at a slower pace. This will potentially weigh on the bond market especially in the emerging markets.
In addition, the longer the rate stays elevated, the longer the damage it will have on the economy. Our base case is that the economy will be tipped to a recession in 2023. The timeline of when this will happen is still uncertain. However, once the fear of recession mounts, market sentiment will turn negative. Emerging market bonds which are generally considered risk-assets will suffer and money will instead flow towards U.S. investment grade bonds especially U.S. treasuries.
Now let us take a look at what happened to PCY in the past two recessions. As the chart below illustrates, PCY delivered a total loss of nearly 50% and 27% in 2007/2008 and 2020 respectively. These returns are much worse than US treasuries and investment grade bonds. As can be seen, Vanguard Long-Term Treasury ETF ( VGLT ) which consists solely of U.S. treasuries and Vanguard Long-Term Bond ETF ( BLV ) which consists of U.S. investment grade bonds have performed much better during the past 2 recessions. If a recession comes, PCY is likely going to see another year of abysmal loss.
Investor Takeaway
Despite PCY offering an attractive yield north of 8%, we do not think investors should jump in right now. As we have illustrated in our article, the worst has yet to come especially if a recession arrives. The risk outweighs the 8%-yielding distribution. Therefore, we think investors should avoid owning PCY now.
Additional Disclosure : This is not financial advice and that all financial investments carry risks. Investors are expected to seek financial advice from professionals before making any investment.
For further details see:
PCY: The Worst Has Yet To Come