Danger Lurks in Favorite Emerging Bond Trade After BrexitBy
Longer-dated bonds have offered top returns since U.K. vote
Wagers on lower-for-longer scenario imperiled by growth
Longer-maturity debt from Mexico to Russia has become one of the most popular post-Brexit trades on bets a split European Union will cause global growth to stagnate and thwart central-bank rate increases.
It’s also leaving investors more vulnerable than ever before.
Holders of longer-dated notes of emerging-market sovereigns are more prone to suffering losses in the event the rally sours than they have been at any point since at least 2006, according to a Bank of America Corp. index. Government debt in developing countries due in more than 10 years has rewarded investors with 6.3 percent returns since Britain’s June 23 vote to exit the EU, almost double the average across maturities.
The risk now is that after loading up on the most rate-sensitive securities as a refuge from the $9.6 trillion of developed-market sovereign debt carrying negative yields, traders may have set themselves up for a hard landing if wagers for the Federal Reserve to raise borrowing costs this year are put back on the table. The odds for a Fed rate move in 2016 jumped to 34 percent from 12 percent last week after data showed U.S. jobs grew the most in eight months.
“Admittedly we are in a lower-for-longer world, but I would be more cautious about buying at these levels," said Viktor Szabo, who helps oversee about $10 billion in emerging-market debt at Aberdeen Asset Management Plc in London. "Treasuries can jump up and then it’s not good to be at the wrong end of the curve.”
The effective duration of emerging sovereign bonds, which is measured in years and determines how much prices are likely to change when interest rates move, surged to an all-time high of 6.5 years in April and is nearing the same level again, according to a Bank of America gauge. That translates into a 6.5 percent decline in price for every percentage-point increase in yields.
For some, the reward of the trade outweighs the risk. BNP Paribas SA and Aviva Investors are betting that long-duration emerging-market bonds will continue to rally as investors are pushed into riskier assets to escape historically low returns in the developed world. Current odds don’t favor the Fed raising rates until September 2017.
“Given the adjustment lower in core rates which we believe is likely to be sustained, emerging-market spreads are likely to compress lower,” said Aaron Grehan, a London-based fund manager who helps oversee $4.5 billion in emerging-market debt at Aviva and thinks long-duration bonds in Peru and Dominican Republic look attractive. “Certainly the environment favors an allocation to longer duration assets.”
Yields on Peruvian dollar bonds maturing in 2050 have dropped 50 basis points to 4.05 percent since the U.K. referendum. The rate on Dominican Republic securities due in 2045 has fallen 79 basis points to 6.08 percent in that period.
The increased appetite is encouraging countries to issue longer-dated bonds to lock in lower rates, which could further compound the risks taken on by investors. Qatar sold $2 billion of 30-year bonds on May 25 with a 4.625 percent coupon, 39 basis points less than investors demanded to hold the country’s 2042 bonds earlier this year.
A month earlier, Argentina had little problem finding buyers for its first debt sale since its record $95 billion default in 2001, which included debt due in three decades.
The biggest risk to holders of long bonds is that Brexit turns out to have limited contagion on the global economy, giving the Fed little reason to keep interest rates near zero, according to Anton Heese, a strategist at Morgan Stanley in London.
Buying securities maturing far in the future is tantamount to a bet that growth and inflation will remain anemic for years to come, even as a U.S. recovery gathers pace. Aberdeen’s Szabo and Kieran Curtis, a money manager at Standard Life
Investments Ltd. in London, prefer to find returns in shorter-duration bonds of sub-investment grade countries.
“You can’t stay in bonds with very low or negative yields, you will be forced
to buy into something riskier, or you have to add duration,” said Szabo. “It makes sense to be long risk, but it’s not necessarily duration that will give you the best return.”