The deterioration in political and economic environment in Brazil is a cause of worry as the portfolio holds 10% of Brazilian bonds denominated in USD. If the situation degrades further, it could result in increased credit risk due of two types, either due to downgrade of credit rating by the credit rating agencies or default on the payment. Either of the situations would lead to decline in value of the bonds and affect the whole portfolio.
A downgrade in bond rating would lead to increase in the yield, resulting in decline in bond value. On the other hand, there could be actual default if the situation becomes worse and there are no cash flows to service the bond payments.
There can be two solutions, either buying a credit default swap (CDS) on the bond or decreasing the exposure towards the bond. The former solution will maintain exposure to the Brazilian bonds in case the condition improves, while at the same time providing insurance that in the case of any credit event, the losses would be transferred to the CDS seller and not absorbed by the portfolio (Pinsent, 2015).
The second solution decreases or completely exits the bond exposure, thus mitigating any risk that could arise. However, if the situation improves, the portfolio would miss out on the increase in bond value. So after considering the whole situation, I would recommend decreasing the exposure instead of buying CDS as the spreads are too wide and chances of fast recovery are very slim (Quinsonas, 2015).
Most of the developed nations are experiencing low interest rate environment. Also, the enthusiasm about emerging economies has become a bit subdued recently. The things that need to be considered while deciding on the future investments are related to the credit risk that would exist if investment is made in emerging economies, the decline in liquidity in some of the markets and the interest rate risk that exists in the markets due to increased volatility which may prompt central banks to increase the rates.
At present the portfolio does not have exposure to Indian sovereign bonds. Historically, in the last five to seven years, the yield on Indian G-sec has been between 7% and 8% for the 10 year bond (Trading Economics).
This is higher than the yields of all other assets in the portfolio at present except Brazilian bonds, which however have much higher credit risk at the moment.
Many researchers and agencies have been saying that investing in India currently is better than investing in any other market. Also, there are no significant risks related to this investment, neither credit risk nor too much interest rate risk as the central bank has been decreasing the rates and there is a push for even lower interest rate regime (Harjani, 2015).
After taking the above two points into consideration, I would sell off only 5% of the Brazilian bonds at the moment as they offer higher yield than any other asset in the portfolio currently (Trading Economics).
I would buy roughly 10% exposure to Indian sovereign bonds. To accommodate this buy, I would sell 5% Saudi Government bonds denominated in SAR in addition to the sale of 5% Brazilian bonds. The yield on Indian sovereign bonds in much higher than Saudi bonds while there is very low risk as compared to the risks associated with Brazilian bonds.
For the moment, I would keep the rest of the portfolio allocation as it is.
Reference List
Quinsonas, C. D., 2015. Brazil is not Russia so don’t expect Brazilian bonds to deliver Russian returns, [online] 13 October. Available at <https://www.bondvigilantes.com/blog/2015/10/13/brazil-is-not-russia-so-dont-expect-brazilian-bonds-to-deliver-russian-returns/>. [Accessed 30 July 2016].
Pinsent, W., 2015. Credit Default Swaps: An Introduction, [online] 17 November. Available at <http://www.investopedia.com/articles/optioninvestor/08/cds.asp>. [Accessed 30 July 2016].
Trading Economics. Government bond yields, [online]. Available at <http://www.tradingeconomics.com/bonds>. [Accessed 30 July 2016].
Harjani, A., 2015. Moody's ups India credit outlook as economy blooms, [online] 9 April. Available at <http://www.cnbc.com/2015/04/09/moodys-ups-india-credit-outlook-as-economy-blooms.html>. [Accessed 30 July 2016].
