After the recent onslaught of bonds, right now is the perfect time to re-sharpen the battle plan and be ready to make further adjustments to the portfolio. This rout in bonds has emboldened speculators to accumulate record short positions on US treasuries as yields approach 3%. Especially if a pattern of demand can be established in 10 year treasuries near the 3% yield mark, we need to consider taking a bigger step to the opposite side of this position. Time and again, history shows us that it can be quite lucrative to take the other side of speculative positions when they reach extremes like this.
In our portfolios, we haven’t owned a ton of bond risk (interest rate risk nor credit risk) over the past couple of quarters. However, we did pick up a bit more duration in January – which turned out to be a wee bit early! The point of this note is to explain why a good chunk of both of these bond risks in our portfolios is obtained through emerging market bonds (EMB and PCY) and why they could even be in line for an increase.
These bonds contain a little more duration than the Barclays Aggregate Bond Index – so containing it in the allocation does marginally boost interest rate risk – if that is what you are looking to do. The credit risk is still a compelling one for these bonds on a risk adjusted basis. Here are the main reasons:
The case for emerging
- Many emerging countries are earlier in their credit cycles – whereas US is late to quite late with interest rates now very clearly on the rise. This reality of these rising rates has put pressure on bond prices and over the past 6 months or so has materially offset coupon income.
In some cases, like in Argentina interest rates are also on the rise. But in many cases – rates are either static or following. Here is a chart of some of the major issuers in the emerging market bond (US dollar denominated) index which shows rates generally on the decline since early ’16.
2. The credit upgrade / downgrade cycle still has better odds of favoring emerging country bonds as opposed to developed. Among the top issuers, the overall movement is pretty much a neutral with some having moved up and other moving down. However, the picture for developed countries is quite different. In 2011 – the US was handed the S&P downgrade bombshell. Joining the US in downgrades are developed nations like the UK, Spain, Italy, France and Japan. Pretty much fiscally conservative Germany stands alone in remaining intact.
Moving forward, I believe it is quite reasonable to assume there will be continued convergence in the ratings among developed and emerging bonds. If that is the case, we should expect the bond yields to also converge (which of course means investors will be better off in the higher yields offered in EM bonds today). The reason for this belief is underpinned by a couple of key facts: First, many of these emerging economies haven’t taken on the debt that the developed world has. Secondly, they should also continue to grow their economies at a more rapid clip. Middle classes should continue to broaden out, as does the tax base. These are all good things for the underlying credit quality of the countries’ bonds.
In the short run, of course, this asset class can be prone to a crisis – and capital can flight to perceived shelter in these developed country bonds.
- Further insight can be obtained into EM attractiveness is comparing their yields to junk bonds. Junk bonds offer clearly inferior credit profiles to the sovereign bonds, yet have yields that are now only modestly higher. The weighted average rating for the EM bond index is about a BB+, vs. a B+ for the junk index. Meanwhile, the yield premium for junk has moderated through this cycle to a much more reasonable level.
The warnings
This investment case doesn’t come without some warnings. The first is that overall bond duration should be carefully managed. Having shot up near 3% – and having so many speculators short bonds – this is an interesting spot to pick up interest rate risk if some level of support can be established. As we move past the short run though, higher nominal GDP, massive US treasury issuance and a federal reserve in reverse should continue to pressure yields higher. This argument is simply that whatever your duration level is, a significant portion should come from EM Bonds.
The other cautionary tale is the real froth that has shown up in the riskier segments / frontier bonds. In2017, issuance soared in emerging market bonds, with nearly half of it coming from junk issuers.
The debt markets in 2017 clearly showed some froth – and this could be a poster child. But, I still wouldn’t let that keep me from owning higher grade EM bonds. Yes, I absolutely would and do keep credit risk at a minimum at this point where there is very little yield cushion for when things go wrong. But, a good chunk of the credit risk I take would again – come from EM.
Bottom line: after a little correction here, emerging market bonds (US dollar denominated) should be at the top of your shopping list.