JPMorgan Scams Investors With Phantom Yields In EMBI Indexes (#GotBitcoin?)
The bank’s popular indexes for emerging-market bonds overstate yields with defaulted Venezuelan debt. JPMorgan Scams Investors With Phantom Yields In EMBI Indexes (#GotBitcoin?)
JPMorgan Chase & Co.’s widely tracked emerging-market bond indexes have overstated yields for the past 18 months, boosting their allure to investors hungry for alternatives to low-yielding developed-country debt.
The overstated yields are byproducts of an arcane index rule, underscoring how unintended consequences from index makers’ decisions can spread now that investors increasingly favor passive funds. The rule, first developed in the 1990s, allows Venezuelan bonds that defaulted in late 2017 to be included in index-yield calculations.
Demand for emerging-markets debt has been strong this year and it isn’t clear how much the yields of indexes operated under JPMorgan’s Emerging Markets Bond Index, or EMBI, brand influenced investors.
But the EMBI holds a virtual monopoly over indexing in the roughly $1 trillion market for foreign-currency emerging-market bonds and its treatment of Venezuela is having an unusual impact. Shareholders of the world’s largest emerging-markets bond exchange-traded fund, for example, paid a surprise tax bill last year because the ETF owns Venezuelan bonds included in the EMBI index it tracks, a person familiar with the fund said.
“Why are you leaving it in there? It’s so skewed it’s crazy,” said Waleed Shoukry, an emerging-markets bond portfolio manager for the United Nations staff pension fund, about the inclusion of defaulted bonds in EMBI yield calculations.
The flagship EMBI Global Diversified index reported a 6% yield in April, compared with 5.6% if Venezuelan bonds aren’t counted, according to a report JPMorgan distributed to clients in April. Venezuela comprised about 1% of the 72-country index by dollar value but accounted for 7% of its yield because the bonds were quoted around 25 cents on the dollar, resulting in theoretical yields as high as 183%, according to the report.
EMBI indexes include yields from defaulted bonds like Venezuela’s in their composite yields but not in total-return calculations, a person familiar with the index business said. Investors who want index yields that exclude defaulted bonds can subscribe to bespoke indexes from the bank, the person said.
JPMorgan’s EMBI franchise grew out of the bank’s dominant role selling bonds for emerging-market countries such as Brazil, Russia and Indonesia to international investors, who now use the indexes as bellwethers to decide when to buy into the asset class.
Most underwriters, such as Bank of America Corp. , Barclays PLC and Citigroup Inc., sold their bond-index businesses in recent years after regulatory scrutiny of indexing intensified because of alleged manipulation of financial benchmarks such as the London interbank offered rate.
JPMorgan has kept the EMBI indexes in house and tightly controlled information about them, disseminating index composition to clients in monthly PDF documents that are watermarked to discourage sharing. The bank uses watermarks to protect all of its research reports, the person familiar with the index business said.
Neither JPMorgan’s index methodology guide nor the monthly reports specify that defaulted bonds are included in index yields. Some portfolio managers said they learned of the practice after the bank began discussing ejecting Venezuela in February because of a U.S. Treasury Department ban on trading the country’s bonds.
Indexes wield an outsize influence over ETFs, which keep costs low by passively investing based on portfolios constructed by index operators rather than employing active fund managers who do their own analysis. Such funds have increased in popularity as investors grow more fee conscious. The top three emerging-markets bond ETFs manage about $20 billion, up from about $6.5 billion five years ago, according to data from Morningstar Inc.
The EMBI’s inclusion of Venezuelan bonds forced a $15 billion ETF that BlackRock Inc. operates under the ticker EMB into a bizarre conundrum last year because the Internal Revenue Service requires the fund to recognize interest from all the bonds it holds, including unpaid interest on defaulted bonds, a person familiar with EMB said. BlackRock and its accountants wrestled with the issue throughout 2018 before settling on a paradoxical solution, the person said.
In December, the fund sold about 1% of its assets to pay shareholders a roughly $120 million distribution equivalent to what they would have received if Venezuela was still paying its debts. The distribution was taxed as ordinary income, saddling shareholders with a bill of about $15 million to $32 million depending on how many invested through taxable accounts, according to a Wall Street Journal analysis and the person familiar with the fund.
“It’s the last thing BlackRock wanted to happen,” the person familiar with the ETF said. It is unclear how EMB will treat the Venezuelan tax issued in 2019.
JPMorgan operates a $63 million emerging-markets bond ETF of its own, which doesn’t include high-risk countries such as Venezuela.
Financial advisers continue to buy Blackrock’s EMB for their retail customers.
“We have several income-oriented clients who bought EMB this year,” said Angie Robinson, co-founder of Nashville, Tenn.-based HMS Capital Management LLC, which manages about $200 million for individuals and institutions. “It has a nice yield attached to it.”
Ms. Robinson said she was unaware unpaid Venezuelan interest accounted for some of the fund’s distributions and that might create a tax liability. But, she said, she still favors using EMB for her clients because it is the largest ETF of its kind, making it easier for them to trade in and out of.
Bloomberg Barclays Indices operates competing emerging-market bond indexes that also include defaulted bonds and their yields, a spokeswoman for Bloomberg said. An index operated by Deutsche Bank AG that serves as a benchmark for a $3 billion Invesco emerging-markets bond ETF excludes defaulted debt because such instruments are illiquid and difficult to value, a person familiar with the index said.
Investors aren’t the only ones who find EMBI methodology difficult to understand.
Three professors at the Centre for Economic Policy Research in London launched a project last year to analyze sovereign-bond defaults from the Battle of Waterloo in 1815 through 2016. Gathering data from prior centuries was fairly straightforward, but there were information gaps concerning more recent defaults because “the available documentation provided by
JPMorgan on how such cases are treated in their price and return series is limited and opaque,” the professors wrote in a paper published in February. JPMorgan Scams Investors With, JPMorgan Scams Investors With, JPMorgan Scams Investors With