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Short Idea: International Bank Of Azerbaijan Bonds

Summary Russia/Oil Derivative play with downgrade/war/financial/currency de-valuation pressure currently trading in the 90s. 93% of the economy tied to oil, 2015 budget based on $90 oil, in current conflict with Armenia, S&P outlook recently moved from stable to negative. International Bank of Azerbaijan has USD & Euro debt and local currency assets, high customer and industry concentrations and a Moscow subsidiary. (IBAZAZ is accessible via FNMIX , which is a 2.44% Holder Of IBAZAZ 5.625s Of ’19) For those who say Azerbaijan is not tied to Russia… Baku, Fineko/abc.az. The Central Bank of Azerbaijan says that US currency is in feverish demand in the country because of Russia . According to CBA, demand for US dollars increased in Azerbaijan starting from mid-December under the influence of psychological factors due to sudden depreciation of Russian currency. “To maintain stability of the national currency CBA set out $1.127 bn for sale. Before December 2014 the bank purchased $1.27 bn from the market and therefore, its net balance on currency exchange transactions was $0.143 bn last year”, – CBA says. Nevertheless, in December currency reserves of CBA reduced by $1.237 bn, which exceeded its expenses for maintaining stable rate of the national currency by $110.7 million. Azerbaijan and Oil Oil and gas production and exports are central to Azerbaijan’s economy. The country’s economy is heavily dependent on its energy exports, with more than 90% of total exports accounted for by oil and gas exports , according to data from the International Monetary Fund. Progress has so far been “elusive” for Azerbaijan in its efforts to diversify the economy away from a dependence on oil and gas, and it must press a fight against corruption to improve the business climate – International Monetary Fund Azerbaijan’s budget for 2015 is based on a price of $90 a barrel At $109 barrel oil last year Azerbaijan made significant investments in projects include the development of the Azeri-Chirag-Guneshli block of fields, Baku-Tbilisi-Ceyhan oil pipeline and the first stage of development of the Shah Deniz field. (U.S. Energy Information Administration) Azerbaijan’s main producing field, the ACG field, covers 167 square miles and is located 62 miles east of Baku in the Caspian Sea. Operators expected peak production to reach 1 million bbl/d, but production at this field so far failed to reach this target. Production problems have affected ACG output in the past couple years, with unexpected production declines occurring because of technical problems. (U.S. Energy Information Administration) But What About Azerbaijan’s Other Exports? Azerbaijan’s MP, member of the parliamentary committee on economic policy, Rufat Guliyev.: “Today, more than 70 percent of Azerbaijani non-oil products are exported to Russia, Ukraine, Kazakhstan ” But The Company (SOCAR) that Produces the Oil is Owned by the Government of Azerbaijan so They Will Support them, Right ? SOCAR only produces about 20% of the country’s oil output (U.S. Energy Information Administration) The remaining 80% of Azerbaijan’s output comes from the ACG oil fields by the BP-operated Azerbaijan International Operating Company (AIOC) and at the BP-operated Shah Deniz field (which produces oil condensate) AIOC is a consortium of 10 mostly non-Azerbaijani oil companies. (U.S. Energy Information Administration) Azerbaijan – Armenian Tensions = Possible War Update: January 26th: Azerbaijan violated the ceasefire about 800 times along the Line of Contact with Karabakh troops on January 24-25. Over 14,000 shots were fired towards Armenian military positions from guns of various calibers, grenade launchers and mortars, the press service of the Nagorno-Karabakh Defense Army reported. Conflict going on since 1994 Conflict became more serious in 2014 with significant casualties Ilham Aliyev – President of Azerbaijan; August 2014 via Twitter “We will restore our territorial integrity either by peaceful or military means . We are ready for both options.” “Just as we have beaten the Armenians on the political and economic fronts, we are able to defeat them on the battlefield “. Defense outlays will grow 27 percent to 3.8 billion manat ($4.8 billion), exceeding Armenia’s total budget spending of $3.2 billion, Finance Minister Samir Sharifov said in November 2014. On top of a budget already cut significantly due to huge drop in price of oil! (2015 budget based on $90 oil) Defense Spending back at peak levels – 1994 (when conflict started) Bloomberg Data What Happens if Azerbaijan un-pegs their currency to the USD? In June of 2013 the International Monetary Fund recommended Azerbaijan un-peg the Manat to the USD “Republic of Azerbaijan, Selected Issues” IMF Country Report: 13/165 The below table shows Azerbaijan is already on its way to a possible de-pegging of the Manat. (source: “Republic of Azerbaijan, Selected Issues” IMF Country Report: 13/165) THIS JUST HAPPENED IN TURKMENISTAN The Turkemenistan Manat has been rigidly pegged to the USD since 2009 at a rate of 1USD=2,85 MANAT Devalued by 18.6% in January of 2015 Kazakhstan had their currency pegged to the dollar as well…. In February of 2014 they unpegged their currency to the USD and devalued the currency by 19% Ok ok, What Does This Have to Do with The International Bank of Azerbaijan? The International Bank is being privatized and is only 50.65% owned by the government (as of 6/30/14 previously was 60.06% on 12/31/13) Considering that 90% of the country’s exports are oil & gas related it seems a bit strange that the financials list exposure to the industry as only 1.1% of total loans It is impossible to know how much of the loan portfolio is indirectly related to the industry 62% of IBA’s loan portfolio is related to Construction/RE development and Trade/Service industries IBA has a history of extending/renewing loans instead of marking them as past due/non-performing/impaired so we don’t truly know how many loans are in this category The bank has a $2.6B 6-12 month funding gap as of 6/30/14…bigger the gap bigger the risk (up from $2.3B at 12/31/13) IBA has ~$250M of foreign syndicated loans maturing in the first 4 months of 2015 (USD & EURO denominated) IBA has credit agreements with foreign banks which have ~$1.2B and ~EUR200M drawn down on them as of 6/30/2014 These term and revolving loans have various unknown financial covenants As of 6/30/14 the value of IBAs currency forward agreements were diminimus at ($1.1M) Concentration Risk 30 companies account for 42.5% of the total corporate loan portfolio Corporate loan portfolio is ~90% of total loan portfolio 20 Entities account for 93.7% of total guarantees as of 6/30/14 (guarantees total ~$1.6B as of 6/30/14) Moscow Subsidiary= International Bank of Azerbaijan-Moscow As reported in audited IFRS statements at year-end 2013, the bank’s aggregate exposure to the 23 largest customers amounted to 42% of total gross loans or 567% of its Tier 1 capital IBAM’s exposure to construction and real estate sectors stood at 189% of Tier 1 Capital at 12/31/2016 Time for the ISIS on the Cake Azerbaijani media: Embassy increases security in Baku because of ISIS threatening Only in January several articles about ISIS’s threatening to Azerbaijan appeared in international media outlets, and Baku has already taken up special measures related to the security of the leading countries and European state diplomacy, Azerbaijani information portal “Minval.az” reports, referring to the site “Axar.az.” The portal also notes that the European outlet “Another Western Dawn News” has recently published a sensational piece of news about the ISIS threat in Azerbaijan. It reported that Abdul Wahid Khudair Ahmad, the ISIL “Minister of Internal Affairs,” had called on the warriors from Azerbaijan to commence an armed struggle against the Western-backed Azerbaijani authorities. What could happen – Attack on BTC Pipeline Azerbaijan has 3 oil & gas pipelines/routes and 80% of Azerbaijan’s oil exports are done through the BTC pipeline , arguably the largest ISIS target in the country… (click to enlarge) (click to enlarge) (source: U.S. Energy information administration) Do I think it should be trading with a single digit yield in the 90s or even 80s given the above? Absolutely Not. (click to enlarge) (Source – Google Images) Disclosure: The author is short IBAZAZ. (More…) The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article. Are you Bullish or Bearish on ? 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Read This Before Shorting Anything!

Summary Shorting mechanics are a bit more complicated than just betting on a price decrease of a specific security. Short sellers should be aware they are responsible for all payments from that security. If you want to be a holder of record, make sure you aren’t lending out your security. Shorting stocks has the potential of unlimited losses unlike shorting bonds. There are some tactics to shorting and securities lending that may be helpful to know. Shorting is a helpful investment method to protect any portfolio from market downturns or to even take a view on an individual company but it’s something that’s a bit more complicated than just betting on a security’s price decline that investors should be aware of before trading. Here’s a look into it a big further. The basics: Short selling is betting on a price decline of a specific security whether it be a stock or bond. If a person cares to short a stock or bond, he or she will need to borrow the security from a lender, give them an IOU, and sell the security in the market. No person would lend out their securities for free, so the short seller needs to compensate the lender for lending them their securities by paying them a fee (borrow rate). The lender lends their securities, gets an IOU from the lendee to return it to them eventually, and receives a fee for allowing the lendee to borrow them. Just conceptually, if I was a lender who wasn’t getting paid for lending out my securities to a short seller, I am essentially letting a person bet against a security that I’m long for free which is obviously a conflict in investment interests. This fee is determined by the liquidity of the securities lending pool (which is different than the liquidity of the security) and the demand to short those securities. Usually a prime broker will tell you the securities lending availability by checking their “feeds” which tells them different advertisements of size and fees being offered from different sources around the Street. The difference between the liquidity of the security versus the liquidity of the security lending pool is that not all securities are available to be lent out for a myriad of reasons. One cannot judge a security’s borrow availability by how much it trades in the markets. You can think of what the fee will be by supply and demand rationale. If there are a lot of securities available to be lent out, then the fee is low, as you can borrow the securities from a lot of available sources, which creates competition to have the lowest fee (large supply, low demand). If there is a small amount of securities in the lending market and a lot of short sellers wanting those securities, then the fee will be high (small supply, high demand). One needs to borrow the securities before short selling to prevent “naked short selling,” meaning you don’t have the underlying securities to sell. This prevents artificial securities from entering the market and also if a short seller sells me a security without borrowing it, what do I own then? This obviously creates chaos and could cause wild market swings (if I had unlimited capital and could naked short sell, I could just keep selling until I clear out all the bids and depress the security to unjustifiable levels). Let’s explore a bit further: I want to short a stock. I borrow it from person A, give them an IOU, and pay a small fee to them in order to compensate them for lending me the stock. I then sell the stock in the market to person B. Now the stock unexpectedly has a vote and all the holders of record can submit their elections. Who is the holder of record? Who is entitled to vote? Person A or person B? Well the answer is person B. I sold the stock I borrowed from person A to them. The stock settled in person B’s name. Now let’s say the stock pays a dividend. Who gets the dividend payment? Person A or person B? Well person B does from the company, but me, as the short seller, needs to compensate person A for that company dividend and pay it to them. If you need to be the holder of record, make sure your stock isn’t being lent out by your broker. This typically isn’t the case unless you bought the stock on margin. If that is the case, typically you can move your stock into a fully paid cash account in order to be the recorded holder. Always remember, if you are a short seller, you are responsible for all payments and/or coupons/dividends from the security to the original holder you borrowed it from. An example of this, I borrowed a stock from person A for a fee of 1% per year. I short sell this stock to person B in the market at a price of $100. Over the course of the year, the stock paid a $4 dividend and dropped to a price of $95. I decide to close out my position. I buy the stock and deliver it to person A covering my short position and canceling my IOU. It may look like I made $5 because of the difference in price from where I shorted it to where I covered it, but I had to pay a $4 dividend to person A (the $4 dividend was paid to person B from the company) and also pay them a 1% annual fee, which equated to $1 over the course of the year. So I made ($100 – $95) – $4 dividend – $1 fee which equals $0. Also, a little bit more complicated is that you may earn money by borrowing a security by getting a “rebate.” Basically, the money you earn on your short sale proceeds (the money you take in from short selling the security) is greater than the fee you need to pay to borrow the security. But for the most part, investors should figure they need to pay a fee to borrow a security. Even further: The short seller is responsible for the borrow fee and any payments the security may pay out including dividends and coupons. Most short sellers are wary about short selling a stock with a regular high dividend unless they are confident the dividend will be cut or suspended. If the dividend is cut, that infers the dividend yield is less and the stock price will drop to compensate. The same idea applies to bonds. The short seller has to pay the interest coupon to the person that lent them the bond. The person who bought the bond from the short seller is the holder of record and receives the coupon from the company. Risks: Now the risks involved with shorting is something everyone should be aware of. Shorting stocks isn’t for the tepid because unlike being long a stock, your losses aren’t limited. For example, I bought a company’s stock at $10 (I’m long). The most I could lose is -$10 if the company goes bankrupt and goes to $0. So if you are long anything, your ultimate loss is the security ends up worthless and you lose all your invested money. There isn’t a case where the security will have negative value and you will end up owing money. So your risk is capped to a certain point. But with shorting a stock, this is not the case. Your losses are potentially uncapped. For example, I shorted that same stock at $10. The stock then doubles and I lost -$10. The stock triples and I now end up losing -$20. The stock then rallies to $100 and I now lost -$90. The upper bound of where a stock can go is uncapped. There’s no end limit to where a stock can appreciate. Obviously, one can assume a stock bound won’t be infinity because investors would realize it’s trading at insane multiples and would start to sell, but there is no cap to losses like you have being long a stock. Investors can lose more money than they put in. But unlike shorting stocks, there is a cap to losses when shorting bonds. To oversimplify, if I’m short a bond at $99, the most I can lose minus whatever I need to pay for coupons and borrow fees is $1 when the bond goes to par when it matures. Obviously, there are cases where the bond trades above par depending on rates and yields but for simplistic sake, a bond cannot mature above par so that caps a short seller’s losses to a point. Stocks vs. Bonds: As shown above, one might prefer shorting bonds over stocks because you are capped to how much you can lose when shorting a bond that you don’t have when shorting a stock. I certainly feel more comfortable with the cap to how much I could potentially lose. But with that said, you really have to be comfortable with the deteriorating credit quality of a company or sovereign to short a bond. As stated in another article , credit gets paid before the equity holders and is less likely to be impaired due to the capital structure. So if there is real financial trouble, the stock will drop before the credit is feared to be impaired. And if the credit is going to be impaired, the stock is most likely 0. If you want to short a stock but don’t want to have your losses uncapped, then there is always put options, which will do that for you. You are short at a certain price and only risk the premium you paid to buy the put option. What else could go wrong while shorting? Most of the time, just because you borrowed a security from a lender and gave them an IOU doesn’t mean they can’t ask for that security back at any time they please unless you two entered into a term borrow agreement (agreement to borrow the security for a specific amount of time without the risk of being called back from the lender but since the lender is locked in to letting the short seller borrow the security for a specific amount of time they ask for a higher fee) which isn’t common in the lending markets but I have used them before. So if the lender wants the security back and you aren’t ready to cover your short, you have 2 options: Find another lender willing to lend you the securities and deliver it to the first person wanting their securities back and now be short with the new lender. Buy the security in the market to close out your short position prematurely and deliver it back to the lender. If all the lenders at the same time request their securities back, this can cause a “short squeeze,” where all the short sellers have to buy the securities back in the market to cover their short positions artificially inflating the security’s price. Sometimes a large holder of the stock will move their position from a margin account to a cash account in order to cause this (there’s no rule saying you have to lend out your stock if you are a large holder but is generally frowned upon when it causes a wild stock fluctuation). There are other tactics people use when trying to secure borrow, one I mentioned here which can cause a real short seller to show up as a top long holder from their filings. The holder is both long and short the stock to create a riskless “box” position. They sell the long part of the box when the stock appreciates to the price they want to be short at making the holder essentially get short at that level. This just ensures that the short seller has the borrow for hard lending names when they want it and don’t need to find a locate when the stock gets to the level they want to be short at. The filings only show their long position (not their net long and short combined positions) which will make them show up as a top holder of the stock implying they have a long thesis, which they might not have. Long story short, don’t always believe 13-f filings. Conclusion: It’s true, over the long run, the stock market appreciates. But if you listen to Warren Buffett : “Rule Number 1: Never lose money. Rule Number 2: Never forget rule Number 1.” Then you’ve got to use shorting to protect capital during any downturns, periods of volatility, or to hedge your positions, but there are inherent costs and risks associated with it that not all investors are aware of. A balanced portfolio should have a little short percentage to either hedge current positions or to just protect from market fluctuations. Some people are inherently against shorting because you are betting against companies, but shorting does have its advantages. It increases stock market liquidity and can weed out some bad companies and/or outright frauds if used in the idealistic fashion and not just for short-term profits. Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.