Wednesday, February 17, 2010

A Cheap Option: Emerging Markets Debt Has Low Implied Volatility

The PowerShares Emerging Markets Sovereign Debt Portfolio (PCY) is an ETF that invests in U.S. dollar-denominated government bonds of "emerging markets" countries.

The largest holding is the Ukrainian 7.65s of 2013, which are 7.29% of the fund. Ukranian debt yields 11 percent.

Some of the holdings seem respectable, like Russia and Brazil. Others, like long-term Mexican (due 2031!), Turkish (due 2036!), or Pakistani debt, not so much.

In the heady days of fall 2007, shortly after it was introduced, PCY hit its all time high of 26.28, when it was yielding (current yields) roughly 6.4%. Interestingly, it bottomed in October 2008 - months before U.S. equities bottomed - at 14.24, when it yielded 11%. It now trades at 25 to yield, once again, 6.5%.

The debt owned by PCY is pretty long term - effective duration 7.31 years. This means that an increase in yields on emerging markets debt would smash the value of PCY.

In fact, the likely reactions of PCY to any this year's possible events are fascinating, and generally bearish:

  • Dollar denominated foreign yields are priced off of Treasuries. In a Treasuries collapse or hyperinflation scenario, consequently, it will do poorly.
  • There is also the possibility of a flight to Treasuries scenario, during a resumed U.S. or global equities selloff, or during a European or other sovereign debt crisis. In that case, PCY will probably not rally alongside Treasuries - since it consists of emerging market debt.
  • PCY is dollar denominated. In a dollar selloff, despite being foreign debt, it will do poorly.
The only upside for PCY if is emerging market yields drop further. But the spread above Treasuries is not that big. Do you think it will tighten more? Otherwise, do you think Treasuries yields will fall? How would that happen outside of a flight to quality scenario, which would not benefit emerging market rates?

Given that PCY will probably do poorly under three different scenarios that occupy a large expanse of the probability distribution, you would think that this is priced into the options market.

But, the implied volatility of PCY is low - below 10% - matching the low historical volatility it has enjoyed for most of the past year.

So, for those option premiums (the Sept 2010 22.5 puts trade at $0.35), are the option writers being compensated for all of the dark storm-clouds that my three bullet points above constitute?

Not hardly. Therefore, the trade is to snag some of that cheap insurance while Mr. Market is offering it.

Were PCY to yield 10% again, you could expect a 25% haircut, which would give the Sept 2010 22.5 put an intrinsic value of close to $4: 10x current levels. And the extrinsic value, assuming some time until expiration, would probably be quite large as well.


Jason said...

Nice idea. Bear with me here, but could you expound on the point of the dollar weakening being bearish for PCY?

CP said...

The debt owned by PCY is apparently dollar-denominated. If you were, say, bearish on the dollar and bullish on EM currencies, PCY still wouldn't work for you.

Honestly, the real scenario, as far as I'm concerned, is #2.

The fed is going to stop the QE program, which is going to tank the market and cause a flight to safety. That will allow them to sell long term treasuries much more easily and thereby obtain a much longer, more attractive maturity profile.

The motive and opportunity are there!

EM debt will tank with the market and I could see PCY getting chopped in half.

dre said...

I completely agree, unfortunately there is almost no open interest in PCY (486). It could do well as a short against a similar yielding dollar preferred...

CP said...

True, and the only open interest that matters is the Sept 22.5 put, which is now 255 contracts.

Hopefully, they will roll out a December or January series on Monday after OpEx.

But since this is a 30:1 trade if I am right, you don't need to own that many contracts.

And the marketmaker seems to be willing to sell contracts at .35 and unlimited numbers at .4.

Give it a try.