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The Safest Way to Play Sovereign Debt

The yield is beating Treasuries, and an ETF softens the risk


“We still spend more time chasing funds than we do in the studio in creative work.” – Alvin Ailey

With “risk-free” U.S. Treasuries once again nearing panic low levels that are largely below the stated Fed inflation target of 2%, many income-focused investors are turning to emerging economies for higher yields. In many ways, within the “risk-free” universe of government debt, sovereign fixed income is the riskiest, primarily because of political uncertainty and currency volatility. That doesn’t seem to be stopping money from flowing into diversified emerging-market debt.

Strength has been solid since the October low of last year, when the Fall Melt-Up took place. Take a look below at the price ratio of the PowerShares Emerging Market Sovereign Debt ETF (NYSE:PCY) relative to the iShares Treasury Bond 7-10 Year ETF (NYSE:IEF). As a reminder, a rising price ratio means the numerator/PCY is outperforming (up more/down less) the denominator/IEF.

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I’ve drawn in the two major periods of strength and leadership that sovereign debt has had relative to U.S. Treasuries in the past three years. The first was as reflation took hold in 2009 following the March low and recovery in risk assets worldwide. The second was following the October low last year that marked the end of the Summer Crash of 2011. There has been a strong period of recovery since then into 2012.

The trend remains favorable for sovereign debt given yields that are considerably higher than those of Treasuries. If 2012 is a year of reflation, as I’ve been arguing, Treasuries could continue to underperform emerging-market debt on average as long as contagion from Europe’s debt crisis does not hit smaller economies. In the meantime, money continues to favor sovereign government paper.

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