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CHASING
EMBI: THE HUNT FOR HIGH YIELD
by David Shvartsman
Finance Trends Matter
February 9, 2007
Not too long ago, in
the comments section of our site, one of our dear readers suggested a
discussion topic for an upcoming post. The proposed idea: that,
"the high-yield market is really the new investment grade
market".
Well baby, you asked for it; you got it. We aim to please, after all.
What follows are a few bits of insight and analysis into this trend
towards high-risk, high-yield investment in the corporate junk-bond
market and the world of emerging market debt.
First off, a word about the current investment climate. The main idea
behind this post topic is that investment yields and perceptions of risk
are low, pretty much across the globe wherever you look. As we see it,
real returns on US government bonds are basically flat to negative if
you factor in the expenses of taxes and the current rate of inflation
(when judged more honestly than by the government's measures).
Investors have had to look farther afield for higher returns in recent
years. This applies to alpha-seeking hedge fund managers as well as
retail investors and retirees. We've seen more people shrugging off risk
in the current environment, with individual investors seeking returns in
junk-bond funds and emerging market bonds, while the professional
investors juice their performance with carry-trades, leverage and a trip
to the frontier
markets.
For those still operating on the notion that compressed yields and risk
spreads have arised out of a "savings glut", may we instead
point you towards the root cause of this supposed phenomenon. Namely,
the expansion of money and credit on a wildly unprecedented, global
scale. In other words, the "savings glut" might be more
accurately characterized as a "liquidity glut".
This mass of global liquidity sloshing about the globe is a large part
of the reason why so much money and attention has been directed towards
these high risk arenas. Competition in the search for yield is intense.
As Financial Times columnist
John Dizard recently put it:
The rapid tightening in risk spreads over
the past few weeks has left portfolio managers in a bad way. There just
isn’t much discernable value out there. Now they’re picking through
the rubbish piles of junk bonds looking for scraps of yield they can
take back to their hungry clients. If their situation gets any more
pathetic, they’ll have to recruit Bono to raise their year-end
bonuses.
FT reporter Joanna Chung echoes these sentiments in her more recent
report, "EM
bond spreads at record lows". As her article details, spreads
of emerging market bonds (as measured by the JP Morgan EMBI+ index)
continue to narrow against US treasuries.
An excerpt from that piece:
Risk premiums on emerging market bonds on
Tuesday were close to record lows as hopes of a credit rating upgrade
for Brazil spurred another round of buying.
As bond prices rose, the risk premium on
emerging market bonds, as measured by JPMorgan’s EMBI+ index, a market
barometer, touched an intraday low of just 164 basis points over US
Treasuries during trading. The lowest close for the index – 165bp over
US Treasuries – was reached on Friday.
The article goes on to report that an eventual, hoped-for upgrade of
Brazil's credit rating is seen as "an overall positive for emerging
markets", and that despite recent jitters, demand for emerging
market debt remains strong. If anything, risk spreads are expected to
narrow further.
...risk premiums are expected to continue
heading lower this year. Yield-hungry investors are pouring money into
emerging market assets at a time when the supply of sovereign paper is
on the decline. Financially stronger governments are issuing less debt
while buying back old bonds. And investors are scooping up bonds of
emerging market companies and banks instead, among the fastest growing
segments in emerging markets.
The trend of increased complacency towards risk in the hunt for yield
did not begin strictly with the junk bond and emerging-nation debt
markets. In fact, we can go back to 2005 to see evidence of this
behavior among investors bidding for the newly reintroduced 50
year bonds that were issued by leading Western governments.
Are purchasers of ultra-long maturity bonds
being compensated with extra yield for investing longer and taking the
inflation risk? Not quite, it seems. As the Times article pointed out,
due to high demand for long-term bonds, the UK yield curve is currently
inverted and offers less reward for investing longer.[4]
Despite this, pension funds seeking to
avoid shortfalls and appease regulators are not the only buyers in the
market. Hedge funds and insurers were said to account for a notable
chunk of demand in the French treasury’s 50-year auction. [5] Although
the French bonds were “priced to yield just 4.21 percent – only
three basis points above the yield on France’s 30-year debt”, the
issuance was oversubscribed. [6]
The situation is not so different for
corporate issues as one skeptical investment manager has noted. “That
the BBB-rated Telecom Italia was able to raise almost 600 million
[pounds] for 50 years - and at a coupon of just 5.25% - illustrates how
little the market is demanding for risk at present”. [7]
Turning back to the issue of high demand for emerging market and junk
bonds, Martin Hutchinson, writing for the Prudent
Bear website, makes the following points of caution regarding the
current state of the high-yield and emerging debt markets:
This is the ugly secret about B rated
bonds: if monetary conditions remain easy, then increased investor
appetite allows potential defaulters to refinance instead of defaulting,
which in turn keeps default rates low and increases investor appetite.
This has particularly been the case in the last few years, when hedge
funds have been able to raise almost unlimited capital from foolish
institutional investors, leverage themselves to the hilt, possibly in
yen, from foolish banks and then invest the gigantic proceeds in junk
bonds, for their modest additional yield above U.S. Treasuries.
Provided the junk bond market doesn’t
crash, so refinancing of all but the worst rubbish is still readily
available, hedge funds can in any given year achieve with almost
complete certainty a satisfactory return, at least 20% of which will
flow to the hedge fund managers personally. Thus the normal corrective
mechanism of rising default rates ceases to work, and the market spirals
towards bond-market nirvana. Essentially the safety valve on the engine
of speculative financing has been jammed shut.
This is even more the case internationally.
The only thing that ever causes countries to default is a refusal by the
bond markets to finance their deficits. Since in an easy money period,
with generally declining spreads, the bond market is open to all
borrowers, no defaults ever occur. That’s why there has not been a
sovereign default since Argentina went in December 2001. The IMF and
World Bank and the Bush administration can hold conference after
conference congratulating themselves on their superb management of the
international financial system, which has caused the world to be free
from “crises” for half a decade.
In reality the lack of crises is nothing
whatever to do with good management, but is simply a function of excess
liquidity.
Thanks to John Rubino at DollarCollapse.com
for recently highlighting the above quoted passage.
Given all this knowledge, we have to ask the question: what might happen
to throw a wrench in the works and send these trends into reverse? In
other words, what will happen to halt the pursuit of returns at a time
when most investors are (arguably) oblivious to risk?
Could it be the unexpected arrival of a credit crunch that will have
investors bailing out of high risk investments and running for cover? As
Barry Ritholz pointed out on his Big Picture blog, Merrill
Lynch has offered just such a forecast.
Even if, as Merrill's report suggests, European and Asian central banks
are expected to tighten monetary conditions through higher interest
rates, this may not result in truly tight conditions if money
and credit continue to be issued through other channels. However, it
could be enough to scare many investors into thinking that the central
banks will have succeeded in their task, especially if inflation rates
remain underreported across the globe. Be sure to look for signposts on
the road ahead.
We'll leave it there for now. If anyone is interested in learning more
about these trends, please feel free to review the source articles
mentioned here, and if you have some insights to share, provide us with
your feedback.
© 2007 David Shvartsman
Editorial Archive
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INFORMATION
David
Shvartsman
Finance Trends Matter
Chicago, IL USA
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