The Great Emerging Markets Bond Conundrum
There's talk of a great rotation out of bonds and into equities again (I remember that chatter from as far back as 2012). Emerging market bonds are particularly beaten down. The trouble is, not everyone has the luxury of moving from one asset class to another. So what are constrained portfolio managers to do?
Move down the credit curve, has been the call. In other words, give up on the safer company debt from South Korea or India and buy all the junk that you wouldn't usually touch with a 10-foot pole. Sounds crazy? It may be the most rational option available. That said, it will also leave money managers more exposed than ever to defaults, just as they're about to tick up.
In many ways, the bond reallocation is similar to what equity investors have been doing. Stock pickers had been buying defensive sectors -- such as consumer staples -- earlier this year as a way to profit from a slowing global economy. With the recent revival of inflation expectations, they've started to move to cyclical shares, such as financial and industrial companies.
The bond equivalent of those sectors has been corporate securities with the lowest investment grade (BBB or Baa3) or the highest junk rating (BB+, Ba1). That helps explain why debt in those two categories has outperformed for the past two years. However, it's a third segment that looks to have the most room for gains -- notes with a single-B grade. which implies a high likelihood of default.
The discrepancy is especially marked in emerging markets. Even after the recent selloff, the average premium that corporate debentures in the double-B and triple-B brackets pay over Treasuries remains near the lowest in a decade.
In statistical terms, the premium for double-B developing nation debt is 0.4 standard deviation below the 10-year median, while triple-B is 0.3 lower. Single-B company bonds are trading at almost exactly the median.
There's another factor that favors single-B bonds. They tend to mature earlier and have higher coupons, which means they're less sensitive to changes in interest rates. For every 10 basis points that Treasuries increase, losses are much steeper for triple-B bonds than their junk counterparts.
It's a no-brainer, right? If only it weren't for defaults. The reason why single-B companies -- especially those in emerging markets -- offer higher coupons and shorter maturities is because they're also the least likely to repay investors. And as interest rates rise, the probability of that happening increases. (I've argued, by the way, that defaults could be about to snowball in developing nations.)
Don't expect that to stop portfolio managers from piling into the riskiest debt. If every car in the parking lot is overpriced, that creaky old station wagon starts looking good enough, even if you suspect it may not get you to your destination.
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Christopher Langner in Singapore at firstname.lastname@example.org
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