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WhatÆs next after the spring market volatility?
Andrew Miller: Assets from Asia continue to flow into high yield and emerging-market debt. The talk 18-24 months ago was about spreads being tight. But at the time we argued the fundamentals were sound and the spread levels were justified. By the end of 2005, spreads were really tight, and we thought the first half of this year would see some weakness, just as we had May volatility in 2004 and 2005. We thought it might come in the form of a political event; there are a lot of elections scheduled in Latin America. But it was the attack on the Turkish lira and the Turkish central bankÆs slow response that triggered it. Then we got the inflation fears and the change at the Federal Reserve, and everyone questioned the risky assets in their portfolios. In the end, the volatility impacted emerging markets more than high yield.
And the outcome?
The market took a healthy breath. WeÆre not out of the woods yet, but the situation has stabilised. We continue to impress upon clients that these are strategic asset classes that deserve a strategic allocation. If an investor isnÆt already exposed to them, this recent widening of spreads could be a small window.
What kind of total returns do you expect for 2006?
We include EMD and high yield into a global high-income fund. Although thereÆs spread volatility, investors can capture the pro-rata coupon, which on average is 8-9%. The market movements in April, May and June wiped out the gains in January, February and March, so the first half is a wash. The total return for the year in high income should be around 4-5%.
Are investors still buying these asset classes?
Yes. Institutions are still putting them on their books, especially pension funds and financial institutions in oil-producing countries, which need to invest all of this money somewhere.
LetÆs break this down into the two components. WhatÆs the picture for EMD look like?
Emerging market debt is now on average low double-A investment grade. ItÆs a far cry from 1988 in terms of quality, thanks to increased current accounts and foreign exchange reserves, and responsible fiscal policies. The information we receive from issuers is more robust and transparent. And the political risks like the recent elections in Latin America havenÆt been a big problem.
Do you invest primarily in US dollar-denominated debt, or local currency?
We include both, as well as emerging-market corporate issuance.
With these great macro stories, doesnÆt that undermine the high yields from EMD?
ItÆs true that the quality of issuance is rising, and therefore yields and volatility are falling. But EMD remains compelling on a risk-adjusted basis. While investors may not get double-digit returns going forward, they should also remember that this year, overall volatility has been a third to a fifth of previous levels û despite the big swings in June. And new countries like Vietnam and Iraq are coming to the market that still offer high yields.
Yields are still high on a 10-year basis. Argentina defaulted in 2002 but investors still got 10% on EMD that year. Performance remains high. This year is the first in five years in which EMD wonÆt deliver double-digit returns. As long as the fundamentals and commodity prices remain strong, spreads will remain tight but coupons remain high. These will fall over time, but for now, EMD is a great place to go to seek protection from rising interest rates in the US.
Bond managers love to get into a market when they see things going from terrible to bad. Right now it looks more like things are going from bad to decent, but that means there are still alpha opportunities.
What about high yield?
Our portfolio contains about 80% from the US and 20% from Europe. The European holding has risen as more investment-grade countries like Russia have been added to the universe.
From a quality point of view, this isnÆt the same as EMD, because itÆs sub-investment grade. But itÆs less vulnerable to interest-rate risk, because youÆre betting on a companyÆs ability to pay its coupon. High-yield returns are more in line with default rates. A slowing economy will have an impact but itÆs not a direct one, and the likely soft landing wonÆt be enough to create defaults. Spreads may widen but they wonÆt spike.
Why will spreads remain tight?
This reminds me of the period between 1994 and 1996, when spreads were again tight for a prolonged time. Also, issuance over the past few years has been good quality û nothing speculative like before 1997. WeÆre just beginning to see high-yield bonds issued to pay for M&A and leveraged buyouts, so weÆll probably see more defaults in three years, but for now, spreads will remain narrow.
So what about returns û is high yield still attractive?
Returns are lower than in emerging-market debt, but EMD spreads had much further to tighten. Average returns in high yield have been 6-8% for the past 10 years. Going forward, investors should receive about the coupon return, 6-7%, although that could fall sometime around 2009.
Are investors being properly compensated for taking risk?
The people who argue no are those who believe in mean reversion. But this is hard to apply to emerging-market debt because the market has changed so much. The nature of the money invested in EMD has changed. ItÆs not just prop desks buying Brady bonds. ItÆs global pension funds and retail mutual funds. On the high-yield side, issuers are now much more diversified and better understood.
Spreads, of course, will continue to be tested, and investors may get slightly less than coupon returns. Central bankers are so data-dependent, weÆre certain to see more volatility. But last year there were no defaults in double-B rated bonds, and only a few single-B defaults. So why should you be paid more? High-yield issuersÆ balance sheets are solid and emerging marketsÆ GDP growth is strong; these borrowers can pay.
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