Does value exist in HY/EMD?
A high-yield and emerging-market debt specialist argues these asset classes are not expensive.
Kevin Colglazier, CIO, heads up a boutique team of high-yield and emerging-market debt managers at the asset management arm of South AfricaÆs Standard Bank in London. The team manages $1.3 billion of assets.
Why combine high yield and emerging markets, versus other asset classes?
They have a low correlation, their yield characteristics are similar and having both capabilities provides synergy among dedicated analysts. High yield analysts tend to have sharper credit skills, and they can make emerging-market people focus more on this. But high-yield people tend to lack an understanding of the global macro story and including emerging-market expertise can make them more holistic.
Are investors compensated for the risk in emerging-market bonds, given tight spreads?
A lot of people say the market is expensive but I donÆt think thatÆs true of emerging markets. People who say that are probably just looking at the JPMorgan Embi (Emerging Market Bond Index), which means theyÆre missing the trade.
We are absolute-return or total-return investors. We donÆt follow a benchmark or relative-value strategies. The Embi no longer reflects the true emerging-markets universe. It contains too many countries that are investment grade, or near investment grade, or where a lot of debt is being retired or bought back.
So where is the emerging-markets debt universe?
ThereÆs a lot more corporate securities available. And there are local-currency plays. Those are structural factors. ThereÆs also a cyclical story. When the debt markets have had a good run, Embi security spreads will become tight. Then thereÆs a crisis and they blow out. But today thatÆs not how you can find value. The value is to be found in credit and local-currency bonds.
Often these look expensive too.
Some of these are expensive but investors overall get paid fairly for taking these risks. Yes, I agree that a relatively straightforward coupon-paying bond is paying 13%, itÆs not sustainable, because no business can afford that kind of borrowing rate. If the corporate sector goes through some kind of crisis, youÆd see these kinds of companies knocked out of the market.
But there is a fair amount of value. You can find plenty of paper in the three-to-seven year range out of Asia, Latin America, Eastern Europe and Russia paying 8-10.5%. ItÆs not incredibly cheap but yields have been driven to these levels because thereÆs so much global liquidity chasing returns. IÆd rather buy a three-year bond yielding 9% than a lot of other asset classes that have been ridiculously inflated, like property.
What kind of opportunities exist in local currencies?
These come in two types of markets. YouÆve got your Brazils and Turkeys of the world, which are large, liquid and tradable. And then you have other emerging markets that are less liquid but offer attractive yields. IndonesiaÆs had a fantastic run. I also like issues out of Egypt and Nigeria.
What kind of returns can investors expect from emerging markets?
Last yaer the Embi was up about 10.7%. This year, on an abolute-return approach, emerging-market debt can deliver high single digits, maybe low double digits.
Is there a problem in the US sub-prime housing mortgage market?
Yes. It reminds me of the late 1990s when people shouldnÆt have bought tech stocks. There are people who shouldnÆt have bought houses. It will be a drag on the economy. But itÆs not going to tip the economy into recession. There will be a slight cascading effect on the CDO market.
So why did the US markets go nuts when Shanghai stocks fell in February? Concerns about a recession, about the yen carry?
I donÆt quite understand why people got so bent out of shape. IÆm no expert on stocks but the US market doesnÆt seem overvalued. As far as Fed policy goes, there are a few strategists predicting a hike, and a few on the other extreme who think the Fed will cut rates aggressively. I think there may be room for a little cutting.
If we faced stagflation where the Fed were forced to raise interest rates to combat inflation, that would be a shock to the financial system. But itÆs such a low probability. WhereÆs this inflation going to come from? Commodities have come off. The US housing market is soft. I recently purchased a home in the US. You canÆt swing a dead cat in Maine without hitting a new five-bedroom house. Given that, I donÆt see how workers will be able to demand big raises from their boss.
But the US economy wonÆt fall off a cliff, either. Housing is a lethargic trade compared with securities. The Nasdaq suffered an instant, visible decline in 2000. Housing wonÆt do that. The surprise is whether it continues to weigh down the economy for longer than expected.
So where is the risk now?
ItÆs mainly at the securities selection level. The US and European economies are in good shape û theyÆre not great, but theyÆre OK. The global trend of tightening money supply is nearly over. There will be periodic risks of the market getting ahead of itself and a desire to take profits. WeÆre likely to see an LBO too far, which would create a pullback in the market. Or we may see a bond issuance thatÆs too big for the markets to digest, if the underwriters misjudge risk appetites.
What about country risks?
These always exist. But thereÆs been lots of press attention to Venezuela, Ecuador and Bolivia, which are bit players in the world of emerging-market debt, and relatively little about areas of true importance. The business-friendly Felipe CalderonÆs electoral victory over the populist Andres Obrador is a great step in MexicoÆs progression toward being a developed country. WeÆve seen similar stories in Brazil and Colombia.
What is the next question mark in emerging markets?
RussiaÆs election in 2008 will quickly become a focal point. ThereÆs a lot to play for. But whether or not you like [president Vladimir] Putin, RussiaÆs economy is a lot more stable, and there will likely be a succession to a like-minded candidate.
WhatÆs your exposure to Asia?
ItÆs expensive. We follow the Philippines and Indonesia but even there we donÆt see a whole lot of risk. These markets are in much better shape now than they were five years ago.
Where do you find value in high yield?
The various indices have ground in since last year, with a widening in the past two weeks. There have been one or two bankruptcies in Europe. There are some large LBO events in the US. But the high-yield market is disciplined and wonÆt swallow deals that go too far. ThereÆs no obvious macro risk. Corporate balance sheets are healthy. Yields are attractive, whether on the Bunds or Treasuries yield curve. This is a year to collect high-yield coupons.
Why combine high yield and emerging markets, versus other asset classes?
They have a low correlation, their yield characteristics are similar and having both capabilities provides synergy among dedicated analysts. High yield analysts tend to have sharper credit skills, and they can make emerging-market people focus more on this. But high-yield people tend to lack an understanding of the global macro story and including emerging-market expertise can make them more holistic.
Are investors compensated for the risk in emerging-market bonds, given tight spreads?
A lot of people say the market is expensive but I donÆt think thatÆs true of emerging markets. People who say that are probably just looking at the JPMorgan Embi (Emerging Market Bond Index), which means theyÆre missing the trade.
We are absolute-return or total-return investors. We donÆt follow a benchmark or relative-value strategies. The Embi no longer reflects the true emerging-markets universe. It contains too many countries that are investment grade, or near investment grade, or where a lot of debt is being retired or bought back.
So where is the emerging-markets debt universe?
ThereÆs a lot more corporate securities available. And there are local-currency plays. Those are structural factors. ThereÆs also a cyclical story. When the debt markets have had a good run, Embi security spreads will become tight. Then thereÆs a crisis and they blow out. But today thatÆs not how you can find value. The value is to be found in credit and local-currency bonds.
Often these look expensive too.
Some of these are expensive but investors overall get paid fairly for taking these risks. Yes, I agree that a relatively straightforward coupon-paying bond is paying 13%, itÆs not sustainable, because no business can afford that kind of borrowing rate. If the corporate sector goes through some kind of crisis, youÆd see these kinds of companies knocked out of the market.
But there is a fair amount of value. You can find plenty of paper in the three-to-seven year range out of Asia, Latin America, Eastern Europe and Russia paying 8-10.5%. ItÆs not incredibly cheap but yields have been driven to these levels because thereÆs so much global liquidity chasing returns. IÆd rather buy a three-year bond yielding 9% than a lot of other asset classes that have been ridiculously inflated, like property.
What kind of opportunities exist in local currencies?
These come in two types of markets. YouÆve got your Brazils and Turkeys of the world, which are large, liquid and tradable. And then you have other emerging markets that are less liquid but offer attractive yields. IndonesiaÆs had a fantastic run. I also like issues out of Egypt and Nigeria.
What kind of returns can investors expect from emerging markets?
Last yaer the Embi was up about 10.7%. This year, on an abolute-return approach, emerging-market debt can deliver high single digits, maybe low double digits.
Is there a problem in the US sub-prime housing mortgage market?
Yes. It reminds me of the late 1990s when people shouldnÆt have bought tech stocks. There are people who shouldnÆt have bought houses. It will be a drag on the economy. But itÆs not going to tip the economy into recession. There will be a slight cascading effect on the CDO market.
So why did the US markets go nuts when Shanghai stocks fell in February? Concerns about a recession, about the yen carry?
I donÆt quite understand why people got so bent out of shape. IÆm no expert on stocks but the US market doesnÆt seem overvalued. As far as Fed policy goes, there are a few strategists predicting a hike, and a few on the other extreme who think the Fed will cut rates aggressively. I think there may be room for a little cutting.
If we faced stagflation where the Fed were forced to raise interest rates to combat inflation, that would be a shock to the financial system. But itÆs such a low probability. WhereÆs this inflation going to come from? Commodities have come off. The US housing market is soft. I recently purchased a home in the US. You canÆt swing a dead cat in Maine without hitting a new five-bedroom house. Given that, I donÆt see how workers will be able to demand big raises from their boss.
But the US economy wonÆt fall off a cliff, either. Housing is a lethargic trade compared with securities. The Nasdaq suffered an instant, visible decline in 2000. Housing wonÆt do that. The surprise is whether it continues to weigh down the economy for longer than expected.
So where is the risk now?
ItÆs mainly at the securities selection level. The US and European economies are in good shape û theyÆre not great, but theyÆre OK. The global trend of tightening money supply is nearly over. There will be periodic risks of the market getting ahead of itself and a desire to take profits. WeÆre likely to see an LBO too far, which would create a pullback in the market. Or we may see a bond issuance thatÆs too big for the markets to digest, if the underwriters misjudge risk appetites.
What about country risks?
These always exist. But thereÆs been lots of press attention to Venezuela, Ecuador and Bolivia, which are bit players in the world of emerging-market debt, and relatively little about areas of true importance. The business-friendly Felipe CalderonÆs electoral victory over the populist Andres Obrador is a great step in MexicoÆs progression toward being a developed country. WeÆve seen similar stories in Brazil and Colombia.
What is the next question mark in emerging markets?
RussiaÆs election in 2008 will quickly become a focal point. ThereÆs a lot to play for. But whether or not you like [president Vladimir] Putin, RussiaÆs economy is a lot more stable, and there will likely be a succession to a like-minded candidate.
WhatÆs your exposure to Asia?
ItÆs expensive. We follow the Philippines and Indonesia but even there we donÆt see a whole lot of risk. These markets are in much better shape now than they were five years ago.
Where do you find value in high yield?
The various indices have ground in since last year, with a widening in the past two weeks. There have been one or two bankruptcies in Europe. There are some large LBO events in the US. But the high-yield market is disciplined and wonÆt swallow deals that go too far. ThereÆs no obvious macro risk. Corporate balance sheets are healthy. Yields are attractive, whether on the Bunds or Treasuries yield curve. This is a year to collect high-yield coupons.
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