PCY: Risky Investment In Below Investment Grade Sovereign Bonds

~ by Snehasish Chaudhuri, MBA (Finance)

Invesco Emerging Markets Sovereign Debt ETF (NYSEARCA:PCY) mostly invests in below investment grade emerging market sovereign bonds with very high maturity and duration. The weighted average maturity (WMA) stands at 20.6 years, while effective duration also is quite high at 10.26 years. In an environment of rising interest rates, sovereign bond prices tend to fall, and the degree of the fall is higher on bonds with higher duration. As interest rates increase, existing bonds become less valuable because their coupon payments become inferior to those of new bonds being offered in the market. As a result, the market price of these older bonds decreases.

I tested my “Seven-Factor Model for Evaluating Emerging Market Bond Funds” on Invesco Emerging Markets Sovereign Debt ETF and found that this fund is a High-Risk Fund. The portfolio is overwhelmed by non-investment grade bonds and PCY undertakes risks that are disproportionate to its coupon income. Historically, the fund failed to generate attractive total return for its investors, and is not available at a good discount either. The poor credit quality of its assets also raises suspicion over sustainability of its future yield. A detailed discussion will make it clear how PCY performed in those seven most critical parameters.

The Invesco Emerging Markets Sovereign Debt ETF And Its Benchmark Index

Invesco Emerging Markets Sovereign Debt ETF is an exchange traded fund (ETF) launched and managed by Invesco Capital Management LLC. The fund invests in US dollar denominated government bonds of emerging economies with a remaining maturity of at least three years. PCY has invested in 96 government bonds spread over 34 countries. A good thing is that this fund doesn’t make a high bet (by investing a high proportion of its assets) in a particular bond or bonds of a particular country. It has invested 3.4 percent of its assets in sovereign bonds of both Turkey and Oman. The maximum investment in a single bond -Turkey Government International Bond (900123AT7) – at present constitutes 1.19 percent of PCY’s total assets.

The Invesco Emerging Markets Sovereign Debt ETF benchmarks itself with the DBIQ Emerging Market USD Liquid Balanced Index. The Fund selects stocks from this index following a representative sampling approach. As a result, the expense ratio is relatively low at 0.5 percent. However, that’s still high for ETFs, due to its passive nature of investment. The Index tracks the returns of more than 100 US dollar-denominated government bonds issued by various emerging market economies. An important point to mention here is that only a few emerging market economies are selected annually based on some statistical measure. Though the Index is rebalanced and reconstituted quarterly, it doesn’t represent a true reflection of performance of emerging market sovereign bonds. The historical performance of the underlying index has not been impressive.

PCY Failed To Generate Return In Long Term, Still Is Not Available At Discount

I analyze the investibility of emerging market bond funds by evaluating the seven most critical factors for such funds- stock price performance, AUM, annual average yield, level of portfolio diversification, average credit rating, current discount to NAV and future sustainability of its yield. As I select funds only with prices higher than $5, yield higher than 5 percent and AUM of more than $400 million, this fund is in my investment horizon. PCY’s stock is currently trading similar to its net asset value (NAV) of $18.4, and thus investors won’t be able to buy it at a significant discount.

The Invesco Emerging Markets Sovereign Debt ETF has been paying monthly dividends for the past 15 years. It generated a decent annual average yield mostly between 4 to 5 percent. This year, however, the yield is quite high at 6.4 percent, primarily due to a huge drop in its market price. PCY’s share fell by almost 30 percent in 2022. Price performance has also been unimpressive in the remaining years. Despite decent annual average yields, the fund generated an average total return of only 0.3 percent during the past 10 years. Within this period, PCY generated double digit total return only once – in 2019. I don’t think any investor will be attracted by this return over such a long time period. In addition to all these, this emerging market fund undertakes very high risk.

PCY Is A High-Risk Fund, Which Raise Suspicion About Sustainability Of Yield

Although PCY is an emerging market fund, it invests only in 20 markets. The fund has invested less than 9 percent in the BRICS economies, while some of its sovereign bond investments are very risky due to higher probability of defaults. Sovereign bonds of Angola, El Salvador, Nigeria, and Pakistan are rated below B, in which PCY has invested more than 10 percent of its assets. Moreover, almost 65 percent of PCY’s investments are in non-investment grade bonds, i.e. those bonds are rated below BBB. In my opinion, this portfolio is neither truly diversified nor is protected from default risk.

The yield seems to be sustainable in the first instance, because the portfolio of investments is generating an average coupon of 5.73 percent. However, it is sustainable only if there is no default. As discussed earlier, it is difficult to guarantee zero default, as some of the investments involve very high risk. The fund has undertaken disproportionate risk in order to ensure its coupon income. In my opinion, the coupon isn’t high enough to justify an investment of 65 percent in non-investment grade sovereign bonds. With respect to highly risky investments, the fund has invested in 12 sovereign bonds of Angola, El Salvador, Nigeria, and Pakistan on a coupon ranging between 6 to 9.4 percent. Such investments don’t seem to be a wise decision given the iffy nature of some of these economies.

Investment Thesis

Invesco Emerging Markets Sovereign Debt ETF is an emerging market sovereign debt fund from Invesco Capital Management that invests heavily in below investment grade government bonds with relatively high duration. PCY is a robust fund, has an AUM of $1.43 billion, trailing twelve-months (TTM) yield of 6.9 percent, and is currently trading at $18.4. However, according to my “Seven-Factor Model for Evaluating Emerging Market Bond Funds”, PCY failed to generate attractive total return for its investors, and undertook risks that are disproportionate to its coupon income. Its portfolio can’t be labeled as a truly diversified emerging market portfolio. The poor credit quality of its assets also raises suspicion over sustainability of its future yield. The fund is not available at a discount to its NAV. I don’t find reason to be bullish about this fund and assign a sell recommendation.

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